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A Study of Indonesia, Republic of Korea, Malaysia,Philippines,andThailand
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. ThispublicationwaspreparedundertheAsianDevelopmentBanksregionalTechnical 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
1992-1997 Table 1.16 FinancingPatternsofPubliclyListedNonfinancial Companies.1 Listed Firms with Positive Economic V alueAdded.3 GrowthandFinancialPerformanceofPubliclyListed Companies.14 Banking Sector Outstanding Loans.7 Growth Performance of the Top 300 Conglomerates. 1993-1999 Table 1. 1992-1999 Table 1.17 DER of Listed Companies by Degree of Ownership Concentration Table 1.vi List of Tables 1.2 KeyMacroeconomicIndicators Table 2. Indonesia Table 1. 1996-1998 Table 1. 1997 Table 1. 1992-1997 Table 1.6 GrowthandFinancialPerformanceofState-Owned Companies.12 CharacteristicsoftheBoardofDirectors Table 1.18 GDP Growth by Sector.4 Development of the Stock Market. 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 . 1992-1998 Table 2.4 Growth Performance of Publicly Listed Companies by Sector.10 Anatomy of the Top 300 Indonesian Conglomerates. 1986-1996 Table 1.1 Growth of the Banking Sector. 1993-1997 Table 1.21 Nonperforming Loans by Type of Bank.9 OwnershipConcentrationofPubliclyListedCompanies by Sector.11 CharacteristicsoftheBoardofCommissioners Table 1.5 Financial Performance of Publicly Listed Companies by Sector. 1992-1997 Table 1.13 Presence of Board Committees in Listed Companies Table 1. 1992-1999 Table 1. 1996-1999 Table 1.8 OwnershipConcentrationofPubliclyListedCompanies.15 V alue of Stocks Issued and Stock Market Capitalization. 1992-1995 Table 1. 1988-1996 Table 1. 1992-1997 Table 1.19 DER and ROE of Publicly Listed Companies by Sector.3 Subsidiaries of the 30 Largest Chaebols Table 2.2 Foreign Capital Flows.20 ROE of the Banking Sector. 1990-1997 Table 1. 1990-1998 Table 1. 1996-1998 2. Republic of Korea Table 2.
5 Table 2.7 Table 2.26 Table 2. 1993-1997 64 66 66 68 70 71 72 73 75 78 80 82 82 83 84 85 86 87 90 91 120 121 122 126 126 127 . 1994-1998 Financing Patterns of the Top 30 Chaebols.28 Table 2.21 Table 2. 1997 Ownership Composition of Listed Nonfinancial Firms by Control Type. 1987-1997 FlowofFundsoftheNonfinancialCorporateSector.8 Table 2.18 Table 2.10 Table 2. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSectorby Industry Financing Patterns of Listed Companies.29 Table 2. 1992-1997 OwnershipConcentrationofListedNonfinancialFirms.25 Table 2. 1994-1997 Cross-Payment Guarantees of the Top 30Chaebols.17 Table 2.11 Table 2.30 Private Capital Flows to Korea. 1988-1997 OwnershipConcentrationofListedNonfinancialFirms by Industry. 1990 and 1997 Ownership Composition of Listed Nonfinancial Firms by Size.20 Table 2.16 Table 2.22 Table 2. 1988-1997 Features of the 30 Largest Chaebols GrowthandFinancialPerformanceofthe30Largest Chaebols. 1997 OwnershipConcentrationofListedNonfinancialFirms by Firm Size.27 Table 2. 1997 Ownership Concentration ofAll Listed Firms.24 Table 2. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSector. 1988-1997 Ownership Concentration of the Survey Sample of 81 Listed Firms. 1990-1997 InternationalComparisonofRatiosofOrdinaryIncome toSalesinManufacturing GrowthandFinancialPerformanceofSelectedIndustries GrowthandFinancialPerformanceofListedCompanies.19 Table 2. 1988-1997 Ownership Composition of Listed Nonfinancial Firms by Industry.9 Table 2. 1999 InternalShareholdingsofthe30Largest Chaebols.6 Table 2.14 Table 2. 1985-1998 GrowthandFinancialPerformanceoftheNonfinancial Corporate Sector.15 Table 2. 1985-1997 GrowthandFinancialPerformanceofListedCompanies by Size.12 Table 2. 1995-1997 Ownership Composition of Listed Companies.13 Table 2.vii Table 2.23 Table 2. 1997 Ownership Composition of Listed Firms in Selected Countries. 1993-1997 The Top 30 Chaebols Debt-to-Equity Ratio.
13 ADB Survey Results on Shareholder Rights Table 3. 1988-1997 Table 3. 1985-1997 Number of Firms with Dishonored Checks.4 GrowthandFinancialPerformanceoftheCorporateSector by Ownership Type. andAffiliated Banks of Selected Business Groups.11 TotalandPerCompanySales. 1997 Table 3. 1988-1997 Table 3.3 TheCorporateSectorandGrossDomesticProduct.7 GrowthandFinancialPerformanceoftheCorporateSector by Industry. 1997 Table 3.32 Table 2.2 Public Offerings of Securities. 1989-1997 Table 3.8 Ownership Composition of Philippine Publicly Listed Companies by Sector.12 Control Structure of the Top 50 Corporate Entities. 1989-1997 Table 3. 1986-1998 Nonperforming Loans of General Banks.19 Financing Patterns by Firm Size. 1989-1997 Table 3. 1988-1997 Table 3. 1983-1997 Table 3. Flagship Company.22 Foreign Investment Flows. 1992-1996 Table 3. 1992-1999 .20 Financing Patterns by Industry.SectorOrientation. 1990-1999 Table 3. 1988-1997 Table 3.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.1 GDP Growth of SoutheastAsian Countries.5 GrowthandFinancialPerformanceoftheCorporateSector by Control Structure.17 Composition ofAssets and Financing of the Publicly Listed Sector.9 OwnershipConcentrationatCriticalLevelsofControl Over Publicly Listed Companies. 1997 Table 3.15 Financing Patterns of the Corporate Sector.1989-1997 Table 3.16 CorporateFinancing PatternsbyOwnershipType.31 Table 2. 1997 Table 3.18 Financing Patterns by Control Structure. 1988-1997 Table 3.viii Table 2. Thailand Table 4.2 Growth and Financial Performance of the Top 1. 1995-1998 4.33 Net Profit Margins of Chaebols. 1989-1997 Table 3. Leverage Table 3.14 Philippine Stock Market Performance. 1978-2000 Table 4. The Philippines Table 3.6 GrowthandFinancialPerformanceoftheCorporateSector by Firm Size.Profitability andFinancial .000 Companies. 1997 Table 3.21 OwnershipConcentration.1 Public Companies Registered. 1988-1997 Table 3. 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.
3 Table 4.4 Table 4.10 Table 4.2 TheSuhartoGroup TypicalInternalOrganizationalStructureofaPublicly Listed Company in Indonesia CorporateControlStructure:TheCaseofAyalaCorporation CorporateControlStructure:theCaseofLopezGroup 24 25 195 197 . 1985-1999 237 238 239 241 242 243 251 252 256 258 259 260 261 262 264 List of Figures Figure 1.1 Figure 3.2 Figure 3.5 Table 4.17 StatisticalHighlightsoftheStockExchangeofThailand. 1990-1998 Merger and Acquisition Activities.13 Table 4. 1993-1999 Size and Composition of the Thai Financial Sector. and Company Size Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.ix Table 4.16 Table 4. 1986-1999 NumberofNewlyRegisteredandBankrupted/Closed Companies.12 Table 4. Leverage. Ownership Concentration. 1985-1996 Average Key Financial Ratios by Company Size.8 Table 4. 1990-1996 Common-Size Statements of Public Companies by Ownership Concentration. 1993-1999 Key Financial Ratios of Publicly Listed Companies.1 Figure 1.14 Table 4. 1992-1999 Offerings of Debt Securities. 1992-1999 Common-Size Statements for Companies Listed in SET.15 Table 4. 1990-1996 External Debt.7 Table 4. 1985-1996 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand. 1990-1998 StatisticalRelationshipsbetweenCorporateProfitability. 1990-1996 Financial Ratios of Listed Companies by Ownership Concentration. 1990-1996 Financial Ratios of All Listed Firms.6 Table 4.9 Table 4.11 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 supportADBs 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 theeightADBmembercountriesthatparticipatedinthestudysfinalizationworkshop 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 annualgeneralshareholdersmeeting 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 Tobins Q won UnitedStates
Note: In this volume, $ refers to US dollars, unless otherwise stated.
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.
2 Corporate Governance and Finance in East Asia. except utilities.2 presents an overview of the Indonesian corporate sector. were the ones most affected. Section 1. and . 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. how it has affected corporate financial performance and financing.5 percent. contracting by 36. regulatory framework. The study also identifies family-based companies and corporate groups. In this setup. These banks were allowed to operate even if they violated minimum capital adequacy requirements. Malaysia. When the crisis hit the country. It analyzes the weaknesses of corporate governance in Indonesia.6 percent) and trade (-18 percent). II rate reached 58. Vol. the Indonesian economy seemed to be in generally good shape. On the other hand. Although as a percent of GDP the stock of outstanding foreign debt owed directly by the private sector was smaller than that of the Republic of Korea. posted negative growth. no doubt. or Thailand. These were already contributing to high levels of nonperforming loans (NPLs) in the Indonesian banking sector several years before the 1997 crisis erupted. Foreign creditors. and analyzes their importance to the corporate sector in Indonesia. and responses to the financial crisis. 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. this left the Indonesian economy extremely vulnerable. short-term loans were used to finance long-term investments. patterns of financing. Foreign debt reached more than $100 billion. these controlling families had political connections that allowed their companies to enjoy special privileges. In many instances. However. This study reviews the Indonesian corporate sector’s historical development. prior to the financial crisis. placed a high premium on these political connections in assessing the chances of being repaid. Economic growth reached more than 7 percent per year and the inflation rate was kept at single digit levels. highly leveraged companies. the controlling families of corporate groups often established banks to provide funds to affiliated nonfinancial companies. patterns of ownership and control. and how it contributed to the crisis. particularly those with large foreign loans. The scale of the financial crisis exposed weaknesses of the country’s corporate sector.5 percent. All sectors. the currency composition and term structure of corporate foreign indebtedness were causes for concern. The construction sector was the worst hit. To facilitate even easier access to credit. followed by finance (-26.3 looks at patterns of corporate ownership and control. Section 1.
Section 1. . Up until the mid-1960s. 2 Survey questionnaires were sent to 280 companies listed in the Jakarta Stock Exchange.2 1.6 summarizes the major findings of the study and suggests recommendations to improve governance in the Indonesian corporate sector. Despite the oil revenues. substantial volumes of private investment entered the scene.2. in the course of the fight for nationhood from 1942 to 1950. This section reports the results of an Asian Development Bank (ADB) survey on corporate management and control practices in Indonesian publicly listed companies. Not all items in the questionnaires were answered by the respondents. With the relatively liberal laws governing foreign and domestic private investments introduced by the New Order Government in 1967 and 1968.4 analyzes corporate financing patterns. It also examines the statistical relationship between corporate performance and corporate governance characteristics. 1.and large-scale companies were dominated by state-run industrial concerns.2 Section 1. and tobacco industries. Section 1.Chapter 1: Indonesia 3 profiles the corporate sector’s governance characteristics. However. textiles. medium. a gradual shift in public investment away from manufacturing took place.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. In the early 1970s. The industries that emerged were highly import-dependent and reliant on tariff protection. the windfall from oil and gas revenues was an important factor that allowed the Government to promote industrial development via import substitution. while Chinese and indigenous entrepreneurs ran some large businesses in trading. Subsequently. only 40 companies replied—39 are private companies and one state-owned company (Bank BNI). and its response. how it was affected by the crisis. The Government became directly involved in industry as a result of the nationalization of Dutchowned shipping firms and oil companies.5 examines the corporate sector during the financial crisis in terms of its role.
4 Corporate Governance and Finance in East Asia. wood. produced consumer goods. Partly as a result of various government policies.2 The Capital Market The Government reactivated the stock exchange in 1977. the number of firms quoted in the stock market was only 24. Third. the Indonesian industrial sector was quite diverse. the stock exchange was also unattractive to companies trying to raise capital as they could borrow from state banks at very low interest rates. exports of nonoil products (particularly textiles and footwear. Regulations in the banking sector led to equities having higher risk but lower returns than bank deposits. the dilution of corporate ownership. In 1992. many founding owners of companies were reluctant to go public and dilute their corporate ownership. The equity market remained largely unappealing due to a number of factors. a distinct industrial elite started to emerge. mostly nonbank financial institutions and stockbrokers. and employed the bulk of the industrial labor force. . potentially subjects companies to greater regulatory scrutiny. During this period. even when new shareholders do not threaten the control exercised by the original owners. While most of the companies were small. These were families with strong links to the political elite of the New Order. By 1987. Vol. 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). which dominated their respective sectoral outputs and markets. II the currency needed to be devalued periodically under a managed floating exchange rate system to avoid large current account deficits. But these proved counterproductive because they limited the potential for capital gains to prospective investors. Last. 1. But until the end of 1988. the Government shifted its industrial policy toward the promotion of labor-intensive exports. the value of manufactured exports overtook the value of oil and gas exports for the first time. Second. Generally speaking. there were also many rapidly growing large-scale companies and business groups or conglomerates. and related products) had shares in total exports that were rapidly increasing. 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. 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. First. A number of underwriters emerged.2.
In 1988. and increased access of domestic banks to international financial markets. Interest rate regulations on state banks and credit ceilings in general were removed. Since 1977. which were previously constrained to 4 percent per day. Thus. The initial banking sector reform was introduced in 1983. the liberalization of the banking industry allowed banks to determine lending rates for nonpriority loans. companies could no longer enjoy low-interest credit from state banks. The Government also abolished the practice of setting prices for IPOs and removed restrictions on price movements in the secondary market. the controlling shareholder of these SOCs is still the State. state-owned banks were still among the biggest. Table 1.3 The Banking Sector Despite the development of the stock market. During this period. The banking sector. the banking sector has undergone many reforms. more significant reforms were introduced. Further reforms along the same direction and affecting state-controlled banks came in the 1990s. Through the years. However.2. private domestic banks dominated the sector in terms of number and total assets. with a total value of more than Rp8 trillion. The development of the Indonesian stock market also provided a vehicle for the privatization of state-owned companies (SOCs). to date. Partly as a result of these reforms. from 24 in 1988 to more than 300 in 1997. However. the number of listed companies in the stock exchange increased substantially. the legal infrastructure that was supposed to guide the evolution of the banking sector was not backed by effective enforcement. with a total value of Rp16.5 trillion. The Government also allowed foreign investors to buy up to 49 percent of listed shares. reduced restrictions on foreign exchange transactions. which up to then was channeling oil revenues to priority sectors. . the capital market played an increasing role in raising long-term funds needed by the corporate sector. Consequently. the banking sector has been and still is the major source of credit for the corporate sector. These included the opening of the banking industry to new entrants.Chapter 1: Indonesia 5 At the end of 1988. six SOCs had issued equities in the market. The dominance of state banks started to erode. priority credits still enjoyed subsidized interest rates and funding from the Central Bank. began to face competition. However. But in terms of assets per bank. 1. Conglomerates carried out 210 out of 257 IPOs.1 shows that from 1994 to 1998. the number of private domestic banks increased.
8 10 37.3 27 51.6 7 7. Of these. Because regulation was weak.8 391.5 7 7 7 5 15.8 27 200.3 201.4 10 35. Bank Danamon (ranked 7th).4 34 12.8 166 248.1 Growth of the Banking Sector.9 248.3 10 17. But the banking system proved incapable of performing its intermediation function. BCA. II Table 1.9 39 18.9 762.7 351.2 161 214.6 164 144 130 92 387. banks could earn profits even when they did not gather and process information about risk.7 27 37.5 27 66.6 34 14.1 10 47. Bank Danamon.4 789. Both BCA and BUN have shareholders linked to the former President Suharto.0 234 1994 104. . the 10 largest were all affiliated with major business groups.8 31 10. Vol.6 7 12.9 10 11.8 27 147.9 31 9. In terms of assets.5 27 88.8 10 19.5 165 308.9 291. while BUN has been closed down by the Government.5 7 9. 1993 100.4 239 222 208 173 Assets and liabilities were concentrated in the top 10 banks. 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. private domestic banks among the top 10 in 1997 included Bank Central Asia (BCA) (ranked first and linked to the Salim group).6 Corporate Governance and Finance in East Asia.6 240 1996 1997 1998 1999 141.8 29 6.3 30 7. and Bank Umum Nasional (BUN) have failed and the first two are now under management of the Indonesian Bank Restructuring Agency (IBRA).1 240 1995 122.5 528.9 304.9 27 113. 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. and Bank International Indonesia (ranked 9th).2 10 14. The other banks among the top 10 were state banks. Among private domestic banks.
2.88 4.63) (1. Until the onset of the crisis.88) — — — — — — 8. when the financial crisis hit Indonesia. Table 1.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.01 (2.4 Foreign Capital The years of rapid industrial growth attracted a large amount of foreign direct investments (FDIs). the Government allowed foreign investors to own 100 percent of an Indonesian company. November 2000. Between 1990 and 1996. Successive policy deregulation facilitated FDIs in various light manufacturing industries. foreign creditors were eager to provide financing to Indonesia. except in certain strategic sectors. But FDIs were only one form of foreign capital inflows to Indonesia.50 (0. In the 1990s.2. Although these inflows were not nearly as large as those received by Thailand (10 percent of GDP) and Malaysia (9 percent of GDP). especially through bank loans. .11 3. In effect.81 3. In 1994. Most FDIs came in through joint ventures with business groups having strong political connections. there was a phenomenal growth in direct borrowings by Indonesian corporations.74 5. 1990-1998 ($ billion) Type of Flows Net FDI Net Portfolio Investment Foreign Bank Loans 1990 1991 1992 1993 1994 1995 1996 1997 1998 1. they still amounted to a large sum for the economy to absorb. 1. Source: IFS CD-ROM.87 7. FDI flows were strong. foreign investment also had a strong presence in the services and infrastructure sectors. IMF.10 5. initially from Japan and the Republic of Korea.15) — = not available. Joint BIS-IMF-OECD-World Bank Statistics on External Debt.09 1.78 2.09) 1.09) (0. Indonesia received capital inflows averaging about 4 percent of GDP.33 (13. such as metal goods.00 2. and footwear. as shown in Table 1.59 billion in 1996. From the mid-1980s until July 1997.59 4. textiles.48 1.2 Foreign Capital Flows. September 2000. 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.40) (0. Increasingly.01) (0. Net FDI flows increased to $5.
especially the short-term ones. This is lower than the average borrowing rate of 18 percent for loans in domestic currency. In the 1990s. and conglomerates. II Up until the late 1980s. the analysis focuses only on publicly listed companies. the average borrowing rate for dollar loans was 9 percent. Between 1989 and 1992. the average foreign ownership of listed companies was 21 percent. allowing foreign investors to buy up to 49 percent of stocks of a publicly listed company. In November 1998. plus 4 percent for the depreciation of the rupiah. In September 1997. an interesting question is whether standard measures of corporate profitability and performance also indicated the same. The Government relaxed this restriction in 1988. foreign investors began to dominate daily trading. but declined to an average of 25 percent during 19951997. total corporate debt reached nearly $118 billion.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. 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. Capital account liberalization permitted the inflow of foreign capital that fueled the credit boom in the country.2.4 trillion in 1997. Due to data constraints. Domestic corporate debt was about $50 billion equivalent. The following section looks at the growth and financial performance of the corporate sector. Consequently.8 Corporate Governance and Finance in East Asia. participation in the Indonesian stock market was exclusive to domestic investors. This increased to 30 percent by the end of 1993. increasing the total trading value from Rp8 trillion in 1992 to Rp120. Private borrowers preferred foreign loans since these were relatively cheaper. with the onset of the Asian crisis. 1. Vol. . The excessive dollar borrowings made the corporate sector vulnerable to sudden currency fluctuations. From 1987 to 1996. state-owned companies (SOCs). By the end of 1997. 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. The external corporate debt owed to foreign commercial banks was $67 billion. 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. foreign banks became a significant source of financing for the corporate sector. of which two thirds were rupiah-denominated.
8 6. but turned negative in 1997. the average DER increased to 310 percent from 230 percent the .3 shows the growth and financial performance of Indonesian publicly listed companies. 174 firms.4 percent.5 37.7 — = not available. During 1992-1997.9 310.0 12.0 10.5 34.4 31. although the contribution increased over time. The debt-to-equity ratio (DER) was high compared to those of listed companies in Malaysia and the Philippines.2 1995 37. averaging 3.1 220.3 3.0 1. 226 firms.7 percent in 1997. Asset turnover was above 30 percent until 1996. but fell to 24. 1996. Net profits grew at an annual rate of more than 20 percent from 1992 to 1996. Table 1.1 0. but dropped to 1. total sales of listed companies grew at an annual average rate of 31 percent. publicly listed companies as a group contributed less than 10 percent to GDP. Despite such rapid growth.8 230. Average return on equity (ROE) of listed firms was 11.9 37. Return on assets (ROA) was also relatively stable during 1992-1996.5 34. Source: JSX Monthly (several publications).0 64.6 24.0 33.8 percent between 1992 and 1996. Note: The number of firms is not identical for each year. ranging from 220 to 250 percent between 1992 and 1996.4 1993 45. a Value added was assumed to be 30 percent of total sales. The growth of listed companies was sustained by continuing investments. but declined to 0. 1993.0 11.3 Growth and Financial Performance of Publicly Listed Companies.8 220.6 3.1 percent in 1997 when the crisis began to buffet Indonesia.4 1996 18.5 240.7 3. 1995.0 6.3 6.0 3.2 30. while total assets grew at 43 percent.5 3.6 1994 50.6 48. 1994. there were 204 firms.4 38.7 — 250.Chapter 1: Indonesia 9 Publicly Listed Companies Table 1. b Asset turnover is defined as sales over assets. 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 — 3.0 12.2 7.4 1997 7. 248 firms. When the crisis battered Indonesia in 1997. In 1997. and 1992.6 percent in 1997. 250 firms.1 4.0 12. 246 firms.
Table 1. Vol. increased from 0. mining. This indicates that a substantial part of corporate debt was denominated in dollars and unhedged. and trade.3 percent between 1992 and 1996. and property. with ROE falling to -11. Overall.2 in 1997. meanwhile. and services. the companies in the sector did not operate with a high leverage. the mining sector ranked first. When interest rates increased. The same applied to the trade sector. miscellaneous industry. followed by agriculture (Table 1. which operated in nickel and copper mining in 1992 and 1993. property. The consumer goods sector ranked second in terms of ROE. However. real estate. investment. and building construction.73 percent in 1992 to 1.4). indicating its reliance on equity to support growth. II previous year. The finance sector’s contribution to GDP. the property sector was severely affected by the crisis. Most companies in the sector that had unhedged dollar-denominated loans suffered exchange rate losses when the rupiah weakened. finance. The finance. the dominant sector was the finance sector. property. Meanwhile. Four sectors (basic industry and chemicals.5 presents the financial performance of listed companies by sector. This sector was less affected by the crisis. still posting a positive but lower ROE. and services. the mining sector had the lowest DER. the banks eagerly provided credit to property development companies. The Jakarta Stock Exchange (JSX) classified listed companies into nine sectors: agriculture. basic industry and chemicals. investment. Also. in terms of growth of sales and assets. averaging 21. the mining sector had the highest ROE. Before the crisis. real estate.7 percent during 1992-1996. miscellaneous industry. and trade) even posted . From 1995. when the property sector was booming during 1993-1997. although asset turnover was slow. due mainly to the domination of the International Nickel Company of Canada. In terms of sales and asset levels in 1997. it appeared that the performance of listed companies was quite satisfactory prior to the crisis. The ROE levels suggest that high leverage enabled listed companies to achieve high returns on equity. For instance. helped in part by the relatively strong demand for consumer goods. only two sectors (mining and finance) showed a consistently increasing trend from 1992. infrastructure. and building construction sectors had the highest DERs because companies in these sectors found it easy to obtain credit from banks. averaging 17. But the sector’s ROE fluctuated a lot. trade. ROA of all sectors dropped in 1997.64 percent in 1997. the fluctuation in nickel and copper prices contributed to the oscillation of ROE.10 Corporate Governance and Finance in East Asia. consumer goods. ROE fell drastically because the sector had one of the highest DERs. During those years. In terms of share of value added to GDP.
5 1.6 85.4 43.1 (41.7) (27.0 0.3) 53.9 .8 1.0 31.2 13. Infrastructure Finance Trade.2 11.0 (28.5 53.0 16.6 1994 (75.3 51.0 0..1 0.0) 46. Real Estate.1 0.6) 119.6 135.9 1.0 43.6 1.9 0.6 26.1 0. Real Estate. and Bldg. 1992 — — — — — — — — — — — — — — — — — — — — — — — — — — — 0.3 0.2 35.8 29.8 66.6 133. Constn. Investment. Investment.7 — — 11.8 1.5 95.7 133.2 41.8 28.1 71.8 24. Investment.8 32.7 17.3 340..9 0.7 — 36.6 0.4 103.5 0.1 1.7 34. Real Estate.1 16. Investment.0 1996 1997 58.0 24.1 0.5 (8.4 77..1 1.7 40.7) 26. and Services — = not available.5) 6. Industry Consumer Goods Industry Prop.6) 25.9 54.8 62.4 1993 155.4 21.3 0. Constn.9 54.8 50.4 30.3 0.9 25.5 0.8 51.3 92. Infrastructure Finance Trade.1 35.0 22. Industry Consumer Goods Industry Prop.7 90. and Bldg.4 (149. Source: JSX Monthly (several publications).6 (41.9 64.3 1.4) 8.6) 19. Infrastructure Finance Trade.Table 1.5) 49. Industry Consumer Goods Industry Prop.3 17.7) (113. and Services Share of Value Added in GDP Agriculture Mining Basic Industry and Chemicals Misc.4 0.0 1.4 1. Infrastructure Finance Trade.3 31.3 0.2 0.6 15.5 45.1 0.4 30.1 42.1 28.5 1.4) 6.7 (82.9 8.1 0.6 0.3 (203.7) 17.6 0.1 1.8 27.6 (0.4 1.8 0.1 23.9 123.0 64.1 (11.0 0. Industry Consumer Goods Industry Prop.7 43.1 32.7 28.6 24.4 44.0 18. and Services Net Profit Growth Agriculture Mining Basic Industry and Chemicals Misc.7 1995 51.7 62.2 14.9 59.1 — 39. Real Estate.5 9.6 0.3 0.6 51.7 0.4 64.6 22.2) 0.6 83.5 68.5 61.7 112.1 1.0 0.5 1.5 13.0 0.3 31.4 38.7 21.4 Growth Performance of Publicly Listed Companies by Sector.2 41.8) (12. and Services Asset Growth Agriculture Mining Basic Industry and Chemicals Misc.7 54.7 24.6 28.9 36. and Bldg..1 1.0 (192.2 5.1 0.5 (11.1 0.5 92.1 67.9 53. 1992-1997 (percent) Indicator/Sector Sales Growth Agriculture Mining Basic Industry and Chemicals Misc. Constn.5 23.5 28.3) 39.5) 13.1 0. and Bldg.0 68.7 0.0 (20.4 170.0 0.9 14.8) 0.9 31.4 31.8 (76. Constn.1 0.9 (7.4 1.2 59.2 0.
and Services Source: JSX Monthly (several publications).1 6.5 13.7 4.0 160.3 64.8 44.0 110.9 41.0 190. 1992-1997 (percent) Indicator/Sector Debt-to-Equity Agriculture Mining Basic Industry and Chemicals Misc.6) 36.1 7.2 13.8 25.2 (4.2 7.1 11.9 14.0 80.1 4.0 8.1 89.0 110.0 120.2 3.7 46. and Services Asset Turnover Agriculture Mining Basic Industry and Chemicals Misc.4 35.7 1.0 3.0 (0.0 170.2 53.2 111.0 110.3 33.0 150.9 40.0 100.0 380.7 12.1 1.4 6. Industry Consumer Goods Industry Prop.3 5. 1992 20. and Services Return on Assets Agriculture Mining Basic Industry and Chemicals Misc.6 8.0 110. Infrastructure Finance Trade.0 130. Infrastructure Finance Trade.0 180.7 10. and Bldg.0 150.1 4.7 10.0 80.6 1. Real Estate.1 1996 100.0 120.0 15.0 8.3 17.6 18. Real Estate.2 6.1 13.7 9.7 4.4) (1.3 7.0 140.4 6.3 73.0 39.. Real Estate.1 9.0 110.8 9.5 Financial Performance of Publicly Listed Companies by Sector.4 4..2 15.0 160.0 90.0 120.8 479.4 35.0 86.2 1993 130.6) 18.1 10.0 66.8 16.0 160.1 9.0 100.6 14.1 2.5 1995 80.4 79.8 382.4 1.0 12.3 17.0 110. Infrastructure Finance Trade.4 5.0 100.7 (3.2 7.7 5.1 3.7 12.0 14.0 180.9 17. Industry Consumer Goods Industry Prop.3 1.2 23.0 110.0 220.9 29.4 71.1 (3.2) 15.7 61.2 3. Investment.7 10.6 23.6 (2.3 13.9 10.1 65.8 11. Investment.0 70.8 67.2 39.0 180.2 8.3 7.0 9.0 50.6 13.5 7. and Bldg.7 5.2 11.5 56.0) 7.7 1.4 17.6 8.0 3.7 4.6 (11.0 11.8 11.7 8. Infrastructure Finance Trade.0 1997 230. Investment.0 150.0 210.5 14.0 70.0 700. Real Estate. Industry Consumer Goods Industry Prop.3 38.3) 5.1 1994 80.0 190.5 19..7 26. and Services Return on Equity Agriculture Mining Basic Industry and Chemicals Misc.0 140.8 81.2 30. Constn.0 19.8 3.3 18.9 38.0 70.9 38.Table 1.5 4.8 168.1 4.1 8.0 60.0 190. Investment.0 560.5 17.7 71.0 17.0 100.7 8.4 . Industry Consumer Goods Industry Prop.1 10.6 19.6 13.1 (5.8) 8.4 20.0 69.9 7.7 12. and Bldg.4 13.0 650. Constn.7 13.4 46.1 10. Constn.4 46.9 4.0 630.5 5. and Bldg.8 20.5 43.0 80.9 42.5 11.2) 7.8 8. Constn.4 13.1 63.5 4.0 680.3 0.0 46.9 87..0 120.6 74.0 650.8 5.
State-Owned Companies At the end of 1995.6).Chapter 1: Indonesia 13 negative ROA. growth of net profits and assets was erratic. banks (seven companies).1 percent in 1993. the ratio decreased from 8. Similarly. By 1995. but dropped dramatically to 4. These growth rates were low compared to those for listed companies during the same period. Only the agriculture sector showed an increase in ROA in the couple of years before 1997. The finance and miscellaneous industry. much lower than that of companies listed in the stock exchange. Asset turnover rates were lower relative to those of publicly listed companies.3 trillion. but it continuously declined from 370 percent in 1992 to 250 percent in 1995.3 percent in 1995. This was relatively high compared to the 3. However. SOCs’ sales growth fluctuated during 1990-1996. While asset turnover rates of publicly listed 3 4 SOCs are those in which the State has at least a 51 percent equity interest. and basic industry and chemicals sectors had relatively stable ROA before the crisis.1 percent in 1992 to 28. there were 58 SOCs with subsidiaries and affiliates. respectively. SOCs diversified into many businesses.6 to 8. the SOCs’ value added as a percentage of GDP ranged from 6 to 8. ROA had been at high levels from 1992 to 1995.8 percent between 1992 and 1995 (Table 1. This was due to large sales by the National Oil Company (Pertamina). Taken together. there were 165 state-owned companies (SOCs)3 in Indonesia. and finance company (four companies). registering an average annual rate of 10 percent. Just like private companies. which collectively had the largest assets. Trade had the highest ROA of 39. Six SOCs were listed in the Jakarta Stock Exchange. between 1993 and 1995. The Department of Mining and Energy ranked first in terms of sales of SOCs under its control. increasing from 21. .7 to 7 percent for publicly listed companies. insurance (11 companies).4 percent the following year. SOCs’ ROE ranged from 6. indicating SOCs’ declining contribution to GDP. the subsidiaries and affiliates number 459 with total assets of Rp343. averaging 24 and 31 percent. The sectoral distribution of 165 SOCs is as follows: nonfinancial (143 companies). the Department of Finance supervised 30 SOCs.7 percent. For instance. The DER was slightly higher than for listed companies. SOCs actively operated in various sectors4 under the supervision of “technical” departments. Assuming a fixed ratio of value added to sales.7 percent in 1990 to 6 percent in 1996.
5 Conglomerates This study used available data on the top 300 conglomerates in Indonesia.0 12.4 7.0 28.4 1993 16.0 17. II companies consistently declined over time. but climbed to 30.1 19.3 30. Source: Indonesian Data Business Center.7 16. Assuming a constant ratio of value added to sales.1) 5.2 percent in 1997 (Table 1.1 30.4 13.2 — = not available.6 Growth and Financial Performance of State-Owned Companies.1 12. Table 1. mostly private companies.4 13.6) 260. 1992 — 7.1 trillion in 1990 to Rp234 trillion in 1997. these conglomerates owned 9.2 — 370.4 percent in 1994.6 percent in 1994. In 1997. 1990-1997 (percent) Item Sales Growth Share of Value Added in GDPa 1990 1991 1992 1993 1994 1995 1996 1997 — 17.14 Corporate Governance and Finance in East Asia. 1992-1995 (percent) Indicator Growth Indicators Sales Growth Share of Value Added in GDPa Assets Growth Financial Indicators Debt-to-Equity Ratio Return on Equity Return on Assets Asset Turnoverb — = not available.0 24.3 250. a Value added was assumed to be 30 percent of total sales.1 32.6 1995 25.8 21.7 (2.0 6.7). Their total sales increased from Rp90.5 percent in 1995.2 23.4 percent in 1992 to 28. Source: Indonesian Data Business Center.8 percent in 1990 to 13.7 13.4 16.6 28.0 8.2 18. Vol.7 Growth Performance of the Top 300 Conglomerates.3 12.0 8. b Asset turnover is defined as sales over assets.1 6.6 28.4 13.1 310. Table 1.0 7.7 1994 (9.8 11. SOCs’ asset turnover rates showed a downward trend from 32.766 business units. but dropped to 11. a Value added was assumed to be 30 percent of total sales.8 12.5 3. . the contribution of conglomerates to GDP increased from 12.
and the board of directors (BOD). If the BOC does not perform well. shareholders lose control. In general. is the only shareholder mechanism for monitoring and controlling the BOD. The law also holds the directors and commissioners jointly responsible for decisions made by the company. commissioners. tasked to provide direction to the company. The law explicitly requires approval during the meeting of decisions on strategic issues such as amendment of the company charter (articles of incorporation). and declaration of bankruptcy. the decision to use certain company assets as collateral for bank credit might need BOC approval. This guards against shady intercompany dealings within a group of companies. however. The meeting decides on important issues. For instance. and the accountant. as representative of shareholders. acquisitions. the decision to amend the company charter should be approved by two thirds of shareholders present in the meeting. the legal and regulatory framework of the corporate sector was far from adequate. mergers. The Corporate Law The Corporate Law of 1995 governs the establishment and operation of limited liability companies in Indonesia. tasked with supervising the firm. and consolidations.6 Legal and Regulatory Framework During the 1990s. The law also specifies that the highest “institution” in the limited company is the shareholders’ meeting.2. The actual responsibilities of BOCs vary by company and are stipulated in the company’s charter. and the attendance should at least be two thirds of total shareholders. For instance. a member company might sign a disadvantageous contract with another company where the same controlling shareholder has a higher stake. the Government promulgated a number of laws and regulations to protect investors. By international standards. The law mandates the BOC and BOD to work for the best interests of the company and not just of the shareholders. For example. .Chapter 1: Indonesia 15 1. an approval needs the majority (50 percent plus one) vote. For mergers. The 1995 law requires limited liability companies to set up two boards: the board of commissioners (BOC). The BOD undertakes operating decisions while the BOC participates in strategic decisions and operations review. such as the appointment (or replacement) of directors. A chairman heads the BOC while a chief executive officer (CEO) heads the BOD. except in strategic issues stated in the law. The BOC. The law replaced an earlier statute that was based on the Dutch system. The company charter details the issues that need shareholder meeting approval.
Vol. such as custodian banks and the securities registration bureau. investment managers. (iv) cumulative voting for directors. delineating the tasks and responsibilities of the Capital Market Supervisory Agency. investment advisors. Because of such requirements. . It also regulates reporting and auditing procedures. (xii) mandatory disclosure of connected interests. and administrative and legal punishment. the decision should be approved by three fourths of the shareholders present. A tender offer is also required for acquisitions of up to 20 percent of listed shares. 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. and guidelines promulgated by the head of capital market supervision. (xiv) mandatory disclosure of intercompany affiliation such as affiliated lending or guarantees. (iii) proxy voting by mail. An important rule is the requirement for independent shareholders’ approval for arrangements that might lead to conflicts of interest. (ii) proxy voting. It regulates the requirements of investment companies. (viii) the right to make proposals at the shareholders’ meeting. (vi) one share one vote. (ix) mandatory shareholders’ approval of interested transactions. and (xviii) severe penalties for insider trading. consolidations. securities companies. The law provides the following rights to or protection of shareholders: (i) access to regular and reliable information free of charge. underwriters. (x) mandatory shareholders’ approval of major transactions. and the attendance should at least be three fourths of total shareholders.16 Corporate Governance and Finance in East Asia. decrees of the finance minister. insider trading (including market rigging and manipulation) investigation. (xvii) mandatory independent board committee. (v) preemptive rights on new share issues. (vii) the right to call an emergency shareholders’ meeting. brokers. The law is supplemented by Government regulations. and other supporting agencies. (xv) mechanisms to resolve disputes between the company and shareholders. 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. (xvi) independence of auditing. II acquisitions. (xi) mandatory disclosure of transactions by significant shareholders. Controlling shareholders have no vote on the matter. transparency requirements. The Capital Market Law The Capital Market Law (1995) regulates companies listed in the stock exchange. and bankruptcy. (xiii) mandatory disclosure of nonfinancial information.
for instance. Banking Laws Affecting the Corporate Sector Some elements of the banking law also affect the corporate sector.. 1. It reveals characteristics of controlling shareholders. For instance. the viability of a project).Chapter 1: Indonesia 17 Bankruptcy Law Despite loan covenants.1 Corporate Ownership Structure Quality of corporate governance is closely related to corporate ownership structure (see discussions in the Consolidated Report of this study).g. Discussions on corporate ownership cover listed companies and conglomerates. However. the Banking Law (1992). holding companies. or 20 shareholders. five. The court can declare the debtor bankrupt upon the request of at least two creditors and default on one loan. or financial institutions. A new bankruptcy law was passed in August 1998. families. net open positions. capital adequacy. whether they are individuals. states that a bank is not allowed to provide credit without collateral. etc.3. the collateral could take the form of nonphysical assets (e. It aimed to protect creditors by providing easier and faster access to legal redress.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. Banking regulations also set lending limits. 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. . Ownership concentration is usually measured by the proportion of shares owned by the top one. The two most important elements of ownership structure are concentration and composition. amended in October 1998. creditors of unsecured loans are unprotected when borrowers fail to meet their obligations. 1. A Commercial Court was also set up to deal with bankruptcy cases.
5 Average 48.0 0. respectively.6 3.5 72.0 2.6 4.18 Corporate Governance and Finance in East Asia.0 67. Data from the Indonesian Capital Market Directory (various publications) show that between 1993 and 1997. When a company makes a rights issue. The percentage owned by each of the five largest shareholders was 48. the controlling shareholders usually act as standby buyers.8 68. This is partly due to the prevailing practice of raising equity through rights issues in Indonesia. and basic industry and chemicals sectors than in others.9 Source: The Indonesian Capital Market Directory.7 1994 48.6 13.5 1997 48.2 67. Table 1.8 1.6 3.5 16.2 11.6. Zebra Nusantara (taxi services).3 1995 47. about two thirds of publicly listed companies’ outstanding shares were owned by corporations that were directly or indirectly controlled by families.7 3. the five largest shareholders owned 68.6 percent. and 0. ownership widely held by the general public is highest in the infrastructure and transportation sector (not shown in the table).6 68. Table 1. Rig Tenders Indonesia (shipping services) issued 51.8. 2. On average.9 14.8 Ownership Concentration of Publicly Listed Companies.0 1.5 12.8 68. issued 93.8 shows average proportions of shares owned by the five largest shareholders of publicly listed companies during 1993-1997.1 0.9 2. II Publicly Listed Companies Table 1. and Berlian Laju Tankers (liquid bulk maritime transportation services) issued 48. 1993-1997 (percent) Shareholder Rank First Largest Second Largest Third Largest Fourth Largest Fifth Largest Total 1993 50. mining.9.1 13. When a company goes public.9 percent of total outstanding shares.5 percent.9 0. This preserves the pro rata share of existing shareholders.0 4.1 1. for instance. 13. 3. Meanwhile.4 percent.9 2. the founder usually continues to own the majority of shares through a . consumer goods. The pattern of ownership concentration changed little over this period.4 2. This is because a few companies in the transportation sector issued high proportions of shares to the public.9 shows that ownership by the largest shareholder in 1997 was more concentrated in the agriculture.7 1996 48.1 4.0 0.2 1. Vol.6.
9 1. in a cross-country study. First Second Third Fourth Fifth Biggest Biggest Biggest Biggest Biggest 54.9 0. Most of the five largest owners of Indonesian publicly listed companies are limited liability companies rather than individuals. the top family controls 16. Investment. and only 0. Real Estate.Chapter 1: Indonesia 19 fully-owned limited liability company (Perseroan Terbatas).4 6.7 6. Industry Consumer Goods Industry Prop.7 percent of the market. that the correlation between the share of the largest 15 families in total market capitalization. Table 1.4 44. as well as the existence of corruption. and Transportation Finance Trade.9 50. 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. Claessens et al.5 4.6 0. Util. In fact.. Thus the founder keeps the proportion of shares necessary to retain control over management of the listed firm. the rule of law. is strong.1 1.2 2.3 2.. 1997 (percent) Sector Agriculture Mining Basic Industry and Chemicals Misc.1 2.6 percent were widely held. on the one hand.3 14.6 2.3 0.2 15.4 11.2 0. and Bldg. (1999) also found.7 4. and the efficiency of the judicial system.1 11. and Services Average Source: The Indonesian Capital Market Directory.0 5.1 2. Indonesia has the largest number of companies controlled by a single family.4 4.1 13.1 percent) of Indonesian publicly listed companies were in family hands. (1999). Constn.8 14.3 36.9 44.6 percent of total market capitalization while the top 15 families control 61.7 13.4 1. Infrastructure.1 0.1 1.1 2. In terms of capitalization. on the other. which shows that in 1996.2 10.5 1.2 46. These figures suggest that ultimate control of the corporate sector rests in the hands of a small number of families.6 1.7 1.9 Ownership Concentration of Publicly Listed Companies by Sector. two thirds (67.2 This is confirmed in Claessens et al.4 54.3 0.6 8.1 1.5 58. Legal and regulatory developments may have been impeded by the concentration of corporate wealth in .3 48.1 0. and corruption.7 9.9 44.1 1.9 3.6 9.
Indigenous businesspeople include the Javanese. Among the top 300 conglomerates. there is a dichotomy between corporations owned by indigenous and nonindigenous businesspeople. was able to create a favorable environment for business development. the onset of the crisis negated this development. foreign ownership increased to 21 percent. Batak. During 1988-1996. Family control is said to have positive effects in that it allows group members in conglomerates to make strategic decisions quicker. the proportion of foreign ownership declined from 27. resulting instead in a decline in the proportion of foreign investor ownership. In 1993. This may indicate that the New Order Government. When the Government allowed foreign investors to buy up to 49 percent of listed shares in 1988. The corruption and regulatory problems generated by high ownership concentration by families in Indonesia are likely to overwhelm its benefits. ethnicity. or other ethnic groups. the Government allowed foreign investors to buy up to 100 percent of listed shares. Sundanese. accounting for 64 percent of total conglomerate sales in 1988-1996. conglomerates established before 1969 dominated in terms of sales. In September 1997. . From 193 in 1988. political affiliation. 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.20 Corporate Governance and Finance in East Asia. Vol. However. However.55 percent in August to 25. most were established during the New Order Government. but later declined and steadied at around 25 percent.42 percent in December. nonindigenous groups owned a larger proportion of the top 300 Indonesian conglomerates. Coordination is easier because informal communication channels exist. it rose to 30 percent.5 Conglomerates Table 1. The nonindigenous businesspeople are usually Chinese. Indian. and family origin. II the small number of families and the tight links between companies and the Government. 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.10 shows the anatomy of the top 300 conglomerates in terms of year of establishment. with all its regulations. In Indonesia. and Padang. numbering 162 in 1988 and 170 in 1996. their number increased to 5 In 1997.
8 12.4 59.8 Source: Indonesian Business Data Centre.9 77.1 25.3 101.4 69.4 59.2 48.1 58.7 49. more than five times its 1988 level.0 58.0 18.0 31.4 16.2 159.9 14.1 41.3 36.8 36.4 31.1 46.4 48.7 89.9 billion.3 20.1 52.8 57.4 31.3 43.8 49.3 80.1 42.8 28. sales of the Bakrie group before it went public in 1990 were only Rp369.1 103.2 23.10 Anatomy of the Top 300 Indonesian Conglomerates. its sales reached Rp1. Meanwhile.5 22.0 44.9 47.6 77.9 35. For instance.9 73.5 21.7 24.9 trillion.4 68.2 29.2 30.8 38.4 86.6 114.7 106.8 30.2 76.4 52.3 120.1 percent of total .4 trillion in 1996.Chapter 1: Indonesia 21 Table 1.6 34.8 25.9 42.6 17.7 40.0 28.4 22.4 32.7 28.5 106.4 18. 204 in 1996.9 13.6 12.4 19. In 1996.4 37. due to their “go public” activities.5 120.7 64.9 137.6 54.1 33.7 95.1 46.4 57.1 21.1 179. Their total sales also increased from Rp38.1 87.6 95.0 15.0 116. the number of mixed groups declined from 86 in 1988 to 68 in 1996. Conglomeration Indonesia 1997.3 134.0 58.4 81.2 12.6 trillion in 1988 to Rp137. While they supplied 20. 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 9.2 33.8 68.4 15.
In 1996. and Ibrahim Risyad of the Salim group. The high NPLs accumulated by banks within official-related groups could be partly attributed to this practice. Prudential credit analysis tends to be ignored. Djuhar Soetanto. Average sales of official-related conglomerates were substantially greater than nonoffficial-related ones during 1988-1996. or have resulted from alliances between entrepreneurs and officials. The well-known official-business alliances are those between Sudwikatmono (former President Suharto’s cousin) and Soedono Salim. compared with the less than Rp700 billion of a nonofficial-related conglomerate. average sales of official-related conglomerates reached Rp1. including Indofood Sukses Makmur (food industry). Official-related groups have owners (or founders) who are or are allied with former or current government officials (or their families). and Wisnu Suhardhono of Apac-Bhakti Karya. for instance. most of the 16 liquidated banks had violated the legal lending limit set by the central bank. But listed companies within conglomerates were few. Banks owned by groups or conglomerates typically act as a “cashier” that provides credit to companies within the group. Only about 13 percent were formed by official or ex-official families.and officialrelated groups. Bank Indonesia. In 1996. More recent alliances were between Bambang Trihatmodjo (former President Suharto’s son) and Johannes Kotjo. In November 1997. Conglomerates were also classified into nonofficial. The contraction in the number and economic contribution of mixed groups may be an indication of increasing social polarization along ethnic lines. there were 175 groups that originated from a family business.22 Corporate Governance and Finance in East Asia. 117 are jointly owned by the family and 57 are owned by individual family members. The Salim group. collectively controlling . which is the largest conglomerate in Indonesia. Some of them later became public companies by listing in the stock market. Indocement Tunggal Prakarsa (cement industry). Vol. II sales in 1988.7 percent in 1996. In 1997 and 1998. But only a handful of these companies are listed in the market. banks that had to be closed down included Bank Surya (owned by Sudwikatmono) and Bank Andromeda (owned by Bambang Trihatmodjo). Most of the top 300 conglomerates were established by ordinary citizens. The Suharto family is the largest stockholder in Indonesia. owns four groups with many subsidiaries and affiliate companies. Out of 174 companies. Bambang Rijadi Soegomo. their contribution declined to 13. Political alliances between entrepreneurs and officials have often led to the violation of regulations meant to promote prudent business practices in the banking industry. and Fast Food (restaurants).2 trillion.
many of whom. Some of the groups related to officials have a unique share ownership structure.Chapter 1: Indonesia 23 assets worth $24 billion (Claessens et al. In 1996. they maintain their position as commissioners. The BOC chairperson often represents the controlling party of the company. but those of the entire group. While the source of the . continue receiving some kind of protection and special treatment. for instance. besides Suharto himself. Although some groups employ professional managers. or both. management. the controlling shareholders are able to maintain their special relationship with officials. 1999). 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. It is generally believed that there are cross-holdings between financial and nonfinancial companies and among nonfinancial firms. If the family members cannot actively manage the companies as directors.. Indofood Sukses Makmur (food industry) was owned by Indocement Tunggal Prakarsa (cement industry). they still control the work of the directors. or someone very close to and trusted by the controlling shareholders. as well as other relatives and business partners. The Salim Group is also in part controlled by the Suharto family. He or she could either be the biggest shareholder. In so doing. and hence. Cases in point are the Bank Papan Sejahtera and Bank Niaga. with no restrictions. The family controls 417 listed and unlisted companies through a number of business groups led by the Suharto children. Indonesian law allows cross-shareholdings. Although they are not actively involved in the daily operations of the companies. Semen Cibinong. The officials (or their family members) often own a small portion of shares given to them freely by controlling shareholders. served in some government function (see Figure 1. But it is difficult to obtain data on cross-shareholding among firms. Cross-holdings between financial and nonfinancial firms potentially create more serious problems. 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.1). families mostly manage the groups and make strategic decisions themselves. Both are listed companies and members of the Salim group. The families retain control of the companies through ownership.
Who Controls East Asian Corporations? Financial Economics Unit. World Bank. and Larry H. 1999). Financial Sector Practice Department.Figure 1.1 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. Lang. . (Feb. Simeon Djankov. P.
one possibility is that legal lending limits had been violated. both controlling and minority. . The discussions are based on the ADB survey of 40 companies listed in the Jakarta Stock Exchange. and accounting and auditing procedures. This is based on the Dutch system.Chapter 1: Indonesia 25 problem is inconclusive. The BOD leads the company and makes strategic and operational decisions. and.2. Shareholders are at the top of the organization. including the boards. role and protection of minority shareholders. Figure 1. the BOC has the right to obtain any information concerning the firm. request a shareholders’ meeting. The typical structure of a publicly listed company in Indonesia is shown in Figure 1. the BOC supervises the work of directors. seek an audience with directors. 1. As the owners’ representatives. Therefore. the directors.2 Typical Internal Organizational Structure of a Publicly Listed Company in Indonesia Shareholders Board of Directors Board of Commissioners M a n a g e r s Employees The succeeding discussions examine some aspects of the internal management and control system in practice in Indonesian listed companies. if necessary. The managers execute the BOD’s decisions and lead employees in their departments.2 Management and Internal Control A company’s internal organizational structure determines how shareholders control management.3. management and managerial compensation.
Corporate Governance and Finance in East Asia, Vol. II
Board of Commissioners and Board of Directors Table 1.11 presents a summary of some characteristics of the BOC. The table reveals that 29 out of 40 companies surveyed did not have independent commissioners. Although 23 companies reported that commissioners were elected based on professional expertise, nine companies reported that selection was based on relationships with controlling shareholders, and another nine reported that commissioners were the company’s founders. Table 1.11 Characteristics of the Board of Commissioners
Number of Firms Responded 11 29 23 9 9 10 22 7 27 7 8 8 30 6 4
Questions Presence of Independent Commissioners a. Yes b. No Basis for Electing the Board of Commissioners a. Professional expertise b. Relationship with controlling shareholders c. As founders of the company Procedure in Electing the Board of Commissioners a. Nominated by the management and confirmed by the AGM b. Nominated by significant shareholders and confirmed by the AGM c. Nominated and elected by shareholders during the AGM Basis for Electing the Chairman of BOC a. Professional expertise b. Shareholdings c. As founders of the company d. Relationship with controlling shareholders Relationship between the Chairman and CEO a. Not related by blood or marriage b. Related by blood or marriage c. No answer
Note: Since companies could answer more than one alternative, the total does not necessarily add up to 40 for each question. Source: ADB Survey.
In most companies (22 out of 40), members of the BOC were nominated by significant shareholders and confirmed at the annual general meetings (AGMs). A nominee that was not supported by significant shareholders
Chapter 1: Indonesia
was unlikely to be chosen as a commissioner. Most companies (27 out of 40) elected their BOC chairman based on professional expertise. The majority of firms (30 out of 40) also reported no relationship between the chairman and CEO either by blood or marriage. A similar picture is obtained for the BOD (Table 1.12). Most companies (30 out of 40) reported not having independent directors. Professional expertise was an important basis in electing directors for 29 companies. Relationships with controlling shareholders and founders of the company were the basis for selecting directors in 11 companies. Table 1.12 Characteristics of the Board of Directors
Number of Firms Responded 10 30 29 7 4 13 22 6 29 3 7 8
Questions Presence of Independent Directors a. Yes b. No Basis in Electing Board of Directors a. Professional expertise b. Relationship with controlling shareholders c. As founders Procedure in Electing Board of Directors a. Nominated by the management and confirmed by the AGM b. Nominated by significant shareholders and confirmed by the AGM c. Nominated and elected by shareholders during the AGM Basis in Electing the Chief Executive Officer a. Professional expertise b. Shareholdings c. As founders of the company d. Relationship with controlling shareholders
Note: Since companies could answer more than one alternative, the total does not necessarily add up to 40 for each question. Source: ADB Survey.
Twenty-two out of the 40 respondents elected their directors through nomination by significant shareholders and confirmation by the AGM. Most companies (29 out of 40) selected the CEO based on professional expertise, although some companies based it on relationships with controlling shareholders.
Corporate Governance and Finance in East Asia, Vol. II
Management and Managerial Compensation The Corporate Law mandates the BOD to lead the company and make strategic and operational decisions, and the BOC to supervise the work of the directors. The BOC also reviews the results of operations and participates in strategic decision making. This indicates some overlapping functions for the BOC and the BOD, which is confirmed in the ADB survey. This overlapping of responsibilities, particularly in making strategic decisions, may result in conflicts. However, since the BOC appoints members of the BOD and determines their remuneration, the BOC is in a strong position to dominate the BOD. Twenty-five out of 40 firms indicated that the CEO makes important decisions after consulting the chairman of the BOC. In carrying out their tasks, the majority of firms reported not having committees to assist the BOD and BOC, as shown in Table 1.13. Only a few companies have nomination, remuneration, and auditing committees, most of which were set up between 1995 and 1997. In 1995, Bank Indonesia required commercial banks to have an auditing committee. Table 1.13 Presence of Board Committees in Listed Companies
Type of Committee Nomination Committee Remuneration Committee Auditing Committee None Total
Source: ADB Survey.
BOD 5 5 5 23 38
BOC 1 1 3 35 40
Most firms reported terms of appointment of three to five years for the BOD and BOC. In some companies, the term differs for commissioners and directors. Although the term is for three to five years, in 13 out of 40 companies, the directors and commissioners have been in service for more than five years. Results of the ADB survey show that in 18 companies, the CEO is given fixed compensation plus a profit-related bonus. In 14 companies, only fixed compensation is given. For the BOC chairman, 10 companies
Chapter 1: Indonesia
provide fixed compensation plus profit related bonus, while 14 companies provide fixed compensation only. Role and Protection of Minority Shareholders Indonesian law requires publicly listed companies to have at least 300 shareholders to help ensure share liquidity and dispersed ownership. The highest number of shareholders is found in Bank BNI (a state-owned bank), reportedly having 27,568 shareholders. Small companies simply comply with the minimum shareholder number requirement. Most companies reported that their shareholders enjoy all mandated rights and protection, except those on proxy voting by mail, cumulative voting for directors, and the independent board committee. A company charter (articles of incorporation) stipulates the quorum requirement during annual meetings, which is usually two thirds of total shareholders. The ADB survey showed that more than 67 percent of shareholders attended the last annual meeting in most companies. While proxy voting is allowed, proxy votes accounted for less than 10 percent of shareholders on average. Brokerage companies and management were the usual proxies. A change in the company charter requires a two-thirds majority vote by shareholders. The ADB survey revealed that in the last three years, only one management proposal (i.e., director’s fee) was rejected during the AGM. This is not surprising because management usually seeks prior approval of proposals from controlling shareholders. Accounting and Auditing Procedures Thirty-five out of 40 respondents in the ADB survey claimed to have substantially followed international accounting standards even prior to the financial crisis. Accounting authorities, however, can easily change acceptable accounting methods. After the crisis, for instance, the Indonesian Accountants Association recommended that potential foreign exchange losses be reported as losses at the end of the accounting year. Later, the association allowed companies to choose between declaring it in the profit and loss statement at the end of the accounting year or in the balance sheet. All companies in the survey reported the presence of an independent auditor, which is usually an international audit company. Most companies have been associated with their independent auditors for more than five years. Shareholders appoint the external auditor during the AGM.
Corporate Governance and Finance in East Asia, Vol. II
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
with the minister’s approval. State ownership for listed SOCs ranges from 25 to 35 percent. The Government is thus able to appoint some officials to be members of the private firm’s BOD or BOC. IBRA found itself tasked with managing large amounts of assets in the private sector. The BOD and BOC of PT Sari Husada were allowed to complete their terms before they were replaced. Another case was the takeover of Bank Niaga in 1997 by Djojohadikusumo. In these two latter cases. The bank was reported to have high NPLs and had broken the legal lending limit. One famous takeover was Bank Papan Sejahtera. restrictions on market entry. appointment of management. to Hashim Djojohadikusumo. who was acquiring his second commercial bank.Chapter 1: Indonesia 31 external acquisitions. The Government appoints the BOD and BOC of these firms. the acquiring parties were trying to obtain operating synergies because they had companies in the same industry. A more recent case was the acquisition by Nutricia (the fourth largest baby food firm in the world) of PT Sari Husada (another baby food firm) in 1998. the owner of Tirtamas group.6 In this case. Before the financial crisis. 6 7 Later in March 1999. Bank Niaga was under a recapitalization program. Wijaya and his friends bought shares of the bank on several occasions until they gained control. a state-owned insurance company may invest its funds in a private firm. Most Indonesian state companies are 100 percent owned by the Government. Control by the Government Government control could be in the form of state ownership. A study by Connie Tjandra (1993) shows that internal acquisitions were often initiated for tax shelter purposes. except for publicly listed SOCs. which was acquired by Yopie Wijaya in 1995. They then replaced the BOD and later sold the bank. . In the massive restructuring of the banking sector that commenced after the crisis. the Government took over NPLs and put them under IBRA management. at a large profit. or direct subsidies. This used to be a common practice in companies associated with the Suharto regime. the takeover brought significant losses to Djojohadikusumo when share prices plunged7 during the crisis. the bank was liquidated. the acquiring interest was apparently seeking economic profits. it was common for the Government to invest in certain private companies. Since the NPLs reached up to Rp300 trillion. However. For instance. In April 1999.
14.3 60.9 150.3 66. Private national banks and state-owned banks were the biggest domestic creditors. bank loans were the only instruments available to the corporate sector for short term (working capital) or long term (investment) financing. However.7 122.5 42. including bonds.3 111. Since then.0 487.7 18.0 6.6 3.4 1.2 5.4 24.0 168.3 9.5 7.6 292.6 150. Data from Bank Indonesia show that from 1994 to 1997.5 108.9 trillion in 1992 to Rp487. private national banks overtook state banks as the dominant credit source.6 6. however. new instruments have been introduced to the corporate sector. . bank credit surged from Rp122.6 percent in 1997.5 80.9 234. 1992-1999 (Rp trillion) Type of Bank State-Owned Banks Foreign Banks Regional Govt Banks Private National Banks Total Source: Bank Indonesia.9 153.4 56.7 112.7 50.6 48.4 225.8 193. when the Government reactivated the stock exchange.2 71. Bank loans. jointly providing almost 90 percent of loans until 1997. companies considered alternatives to bank loans.1 Corporate Financing Financial Market Instruments Prior to 1977. stocks.9 378. and others offered by nonbank financial institutions or finance companies. this market was not well developed. When the Government liberalized the banking industry at the end of 1988 (which allowed for higher interest rates).14 Banking Sector Outstanding Loans.2 27.4 trillion in 1998.4.3 14. II 1.1 Equities In 1977. From 34.2 6.0 3. because of the restrictions discussed below. Vol.32 Corporate Governance and Finance in East Asia.6 4.4 percent in 1992.4 86. remain the major financing instrument for the corporate sector.0 93. Bank Credit As shown in Table 1.1 220. equities became available to the corporate sector. Table 1.3 188. 1992 1993 1994 1995 1996 1997 1998 1999 68. the share of private national banks in outstanding total loans increased to 44.
9 1999 76. 1992 1993 11. The ratio reached 8. but dropped to 8 percent in 1991 when the Government tried to stabilize an overheating economy. i.4 207.6 123.7 14.0 70. factoring. capital adequacy ratio. the stock market has gained a bigger role in corporate sector financing (Table 1.1 18.1 1994 26.6 301. It gradually increased again starting in 1991.g.9 406. In 1988.0 206.5 1995 35. thus increasing the role of the capital market in raising long-term funds.5 Financing by Finance Companies Finance companies first emerged at the end of 1980.1 10.7 9. 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. legal lending limit.5 333. In 1995..e. and consumer credit..8 48. and net open position).7 15. allowed to accept deposit accounts from the public. shooting up to 18. Most banks therefore set up subsidiary finance companies to circumvent banking regulations. 1992-1999 (Rp trillion) Item Stocks Issued Outstanding (As % of Outstanding Bank Credit) Market Capitalization Source: Bank Indonesia. Prior to 1995. credit cards.7 percent in 1997.Chapter 1: Indonesia 33 Some companies went public. They were not.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.6 310. Table 1.15 Value of Stocks Issued and Stock Market Capitalization. the activities of finance companies were not covered by regulations on prudential practices in the banking sector (e.2 16. finance companies were increasingly used as channels for the inflow of foreign loans. the Government issued regulations to supervise and promote prudential practices in finance companies. During the 1990s.15). however.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. Overall. funds raised in the stock market were less than 5 percent of the credit disbursed by the banking sector.1 17.0 15.6 91.4 1996 1997 1998 50.
5 21. Bank Indonesia prohibited banks from underwriting issues of commercial papers but allowed them to act as paying agents. 1996.6 23.0 39.0 100.5 percent and 36.5 — 26. In terms of composition.2 Patterns of Corporate Financing Table 1.4 23.0 — = not available. have been popular in Indonesia since 1990.6 12.4 8.5 11.0 1991-1996 16. PACAP Research Center.16 Financing Patterns of Publicly Listed Nonfinancial Companies.6 8.8 percent. which are unsecured negotiable promissory notes with a maximum maturity of 270 days. This is in contrast to the lower share of borrowings during the same period.1) 23. .6 100. 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).9 16.4 13. otherwise it would be classified as a loss in the banks’ books.16 shows financing sources of Indonesian publicly listed nonfinancial companies estimated by using flow-of-funds analysis.6 100. respectively.3 37.5 (0. While banks had some exposure to these instruments. Thus in November 1995. Table 1. they were not rated by a rating agency. II Commercial Papers Commercial papers.3 (0.0 3.7 22. averaging 26.4.34 Corporate Governance and Finance in East Asia.3 14. publicly listed nonfinancial companies had high proportions of equity and internal finance (retained earnings).0 1986-1996 17. In the second half of the 1980s.1) 23. 1986-1996 (percent) Financing Source Internal Borrowings Short-Term Long-Term Debentures/Equity Debentures Equity Trade Credit Others Total 1986-1990 36. 1. Source: Author’s estimates based on the Pacific-Basin Capital Markets (PACAP) Databases.2 26.8 7. short-term borrowings were greater than long-term debts. Vol. at 81 percent of total borrowings.3 16.8 17.
Most corporate charters require commissioners to approve debt issues or sign debt agreements. The high share of equity financing was due to the surge in capital market activity following the 1988 reforms.9 trillion in 1996.6 trillion and Rp1. which was masked by the rapid growth in investments. that ownership concentration may be associated with heightened risk-taking by companies.1 trillion. All companies in the cement industry suffered from foreign exchange losses. The corporate sector invested heavily from 1991 to 1993 and slowed down its investment spending a few years before the 1997 crisis. Two telecommunications companies.Chapter 1: Indonesia 35 In the 1990s. 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. rising from Rp54. 1. Hence. This amount doubled in 1997.9 trillion. the corporate sector’s high leverage.17 compares the DER of listed firms by degree of ownership concentration. The results indicate that firms with higher ownership concentration tend to have a higher DER. For instance. as evidenced by an average DER of 230 percent during 1992-1996 that rose to 310 percent in 1997. Large shareholders are inclined to undertake risky projects intended to generate high returns using borrowed funds.4.4 trillion in 1993 to Rp112. which managed to post significant profits due to low exposure to dollar-denominated loans. with longterm debts increasing rapidly. except Semen Gresik (an SOC). Corporate debts grew over time. was due largely to a rapid rise in long-term debts. .3 Corporate Financing and Ownership Concentration It has been suggested. the pattern changed. while Semen Cibinong’s losses reached Rp2. These liabilities grew significantly because corporate expansion was largely financed by debt. Table 1.3 percent during 1991-1996. corporate debts accounted for 39. Many companies suffered big losses in 1997 due to their high exposure to dollar loans. Indosat and Telekom. Note that the corporate sector’s high leverage existed side by side with sizable equity capital raised from the capital market.2 trillion. in the context of Indonesia and some other countries. They also do not want to dilute corporate control and are more likely to finance growth with debt. reaching Rp229. respectively. Of the various financing sources.2 trillion (mostly foreign exchange losses). also suffered from foreign exchange losses but managed to post profits of Rp0. Bank loans also surged when the banking sector was liberalized in 1988. Indofood registered losses of almost Rp1.
the private sector borrowed heavily in unhedged dollars.358. heavy reliance of companies on bank credits to finance investments. Inadequate Financial Regulatory Framework Liberalization of financial markets increased the corporate sector’s access to domestic and foreign private capital. II However. 1. since commissioners represent the controlling party.0 351.56 significant at the 10 percent level.0 386.1 The Corporate Sector in the Financial Crisis Causes of the Financial Crisis Many intertwined factors led to the crisis.0 1. aided . decisions on debt are made with the implicit endorsement of owners.36 Corporate Governance and Finance in East Asia. This section highlights those that were seen to have contributed significantly to the crisis in Indonesia: inadequacy of the regulatory framework under the financial liberalization. The availability of bank credit brought by the rapid rise in the number of banks and the free capital flow system led to a credit boom. and high ownership concentration among families with political affiliation. ultimately.5 1.17 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. to maintain control of the company. Source: Author’s estimates. Between 1987 and 1996.5. Table 1. The test of the difference between the two means found the t-value of 1. The low cost of foreign loans and the relatively stable exchange rate created a false sense of security for corporations. As a result. the free capital flow system allowed private companies to borrow dollars offshore without any restriction. Vol.0 Notes: Firms with high ownership concentration have more than 50 percent of shares owned by the top five shareholders. In addition. the borrowings swelled. Controlling parties rely on external financing to maintain their equity share and.
substantial amounts were also funneled into projects that guaranteed repayment mainly on the strength of borrowers’ close political connections. A director at Bank Indonesia revealed that in 1995. 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. In the process. many firms became highly leveraged. However. large amounts of credit were directed to the companies within the group.. . The banks served as a “cashier” that provided easy credit to nonfinancial companies within the group. It was doubly difficult to exercise supervision when groups with political clout owned the banks. It also meant that the cashier bank had neither the independence nor the incentive to exercise ex ante and ad interim monitoring of borrowers.Chapter 1: Indonesia 37 by the lack of an existing mechanism to supervise and monitor foreign transactions. only created to serve the companies to which they lent. after all. did finance many viable ventures. Conglomerates that had difficulty in getting loans (i. the level of corporations’ foreign debt could not even be ascertained. As a result. A lot of short-term foreign funds were used to finance long-term investment projects. However. The Government later specified the legal lending limit and the net open position that banks had to follow. to circumvent these banking regulations. conglomerates set up finance companies and used these as channels for the unfettered inflow of foreign loans in lieu of banks. 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. averaging about 4 percent of GDP. and the negative net open position (short position in dollars) continuously rose to precarious levels. There was also a smaller demand for equity compared to external debt financing since controlling shareholders preferred the latter to maintain their control of the companies. They were. Decisions to borrow in dollars made sense to many borrowers because dollar loans were cheaper than rupiah loans. It was only in 1995 that some regulations on the activities of finance companies were contemplated. This often led to the violation of prudential credit management practices. those with high DERs) established their own banks. The supervising agency was caught unprepared. This left them vulnerable to interest rate surges as well as sudden currency fluctuations in the case of dollar loans.e. It is not known if these regulations had an effect on nonbank intermediaries. The large supply of foreign funds.
Family-controlled corporations were generally structured as a complicated web of affiliates and associated companies. and in the process maintain control of the company. there was also almost universal confidence that the economic growth would continue indefinitely. of which $64. total private sector foreign debt stood at $72. In many cases. Families retain control by keeping the majority percentage of outstanding shares. Vol. 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. but on the basis of who the borrower was. Controlling shareholders also prefer to use debts to finance expansion so as not to dilute their ownership. by setting up their own banks. This was often the case in the banking industry. Corporations were certain that they could roll over short-term loans when these fell due. In early 1998. partly because they used nominee accounts to register ownership rather than set up a holding company. and power generation) require huge capital. or both. They enhance their control over companies through cross-shareholdings. politicians. Collusion between big businesses and the political elite was widespread in Indonesia. where private banks are usually in the hands of big businesses. Since the Government could not afford to undertake these projects. $35 billion of Indonesia’s foreign debt owed to private foreign banks was about to mature in less than one year. There were cases where banks and borrowing companies were controlled by the same groups or families with strong political connections. II By mid-1997. Aside from the fact that many of these loans were channeled through banks and corporations of politically connected families. The ultimate control of the corporate sector rests in the hands of a small number of families who own groups of companies. banks did not lend on the basis of the soundness of the project. most often to people who were close to the ruling regime. . toll roads. and investing shares among nonfinancial companies within the group and in other groups’ companies. as they had done so in the years before the crisis. They ensure that commissioners represent their interests and maintain close relationships with the chairperson.38 Corporate Governance and Finance in East Asia. Projects involving massive capital investments and long-term operating deals (in telecommunications. contracts were granted to the private sector.5 billion. This fact was usually not disclosed in financial statements.
2 Impact of the Financial Crisis on the Corporate and Banking Sectors Impact on the Corporate Sector Table 1.18 GDP Growth by Sector.6 8.5.7) (8.18 shows that growth in most sectors significantly fell in 1997.24 trillion for the first six months of 1998. and Business Services Other Services GDP 1996 3.6) (3.1) (26. as shown in Table 1.1 (1. posted negative growth rates.1) 1. DER and ROE were calculated per sector. and Water Supply Construction Trade. BPS). followed by the finance and trade sectors.Chapter 1: Indonesia 39 1. Gas. Most sectors showed significant increases in leverage.4) 2.8 8.4 5.9 3.6 4. Hotels.58 trillion (meaning their losses were greater than the paid-up capital). when all sectors.0 5.370 percent. and Fisheries Mining and Quarrying Manufacturing Electricity. and building construction.8) (11.7 6.8 0.8 1997 1.8) (13.0) 1999 2. much higher than the 307 percent registered in December 1997. indicating a rapid rise in .3 Source: Central Bureau of Statistics (Biro Pusat Statistik.4 7.0 3.52 trillion. Livestock. 53 companies reported negative equity of Rp6.7 1998 (0.2 (1. Real Estate.3 11.3 12. followed by property. and Restaurants Transport and Communications Financial.6 12. Using the financial statements as of 30 June 1998 of 161 publicly listed companies.4 7.19.2 8. Table 1.7) (2. except utilities.6 (36.7) 2.4) (0. The construction sector was the worst hit.0 2. This continued in 1998.5) (18.1 6.6 13. The JSX Monthly reported that total losses of 214 listed companies amounted to Rp39. Forestry.6) (0. The consumer goods industry reported the lowest ROE.8 7. The average DER was found to be 1.1 5. 1996-1999 (percent) Sector Agriculture. Sectors with lower ROE generally had higher DER.0) (15. real estate. and 128 companies reported a total loss of Rp46. Only 86 companies reported profits.
395.1 30.1 (92.4 (6.6) 15.2) (264.40 Corporate Governance and Finance in East Asia.0 2.0 631.8) 36.0 177. The table also reveals that although private national banks dominated the banking sector in terms of assets and credits.7 percent in July 1998.0 1.0 97.6) (115.370.1 (5.0 12. The huge losses suffered by most companies were caused by three factors.4 5. rupiah values of dollar-denominated debts due to the weakening of the local currency and the rapid decline in equity because of losses.8 percent in 1996. as shown in Table 1. interest expenses rose as credit rates increased from 20 percent in early 1998 to 40 percent in mid-1999.3 7.2 13.8 17.0 177. a Actual data for 1st semester only.6 (11.097. Mostly suffering from a liquidity squeeze. First. and would have kept on increasing if interest rates had not declined.21. several publications.1 1.0 108. . As the rupiah weakened and interest rates increased. Vol.0 158.8 (373.0 1997 234.4) 8. 1996-1998 (percent) DER Sector Agriculture Mining Basic Industry Miscellaneous Industry Consumer Goods Industry Property Infrastructure Finance Trade/Services Average 1996 104.0 191.19 DER and ROE of Publicly Listed Companies by Sector.0 219. private banks posted negative ROEs in the same year. but annualized to approximate full year values.0 a ROE 1996 1997 1998a 14.0) (78.20 reveals that the banking sector’s ROE decreased significantly in 1997.2 (4.0 105. Financial and banking analysts estimate that by September 1998.0 697.1 (3.0 92.0 65.7) 6.9 12.0 864.625. Source: JSX Monthly.0 229. II Table 1.0 1.7 1. This figure further increased to 47. the NPL ratio rose to 25.1) 7.0 1998 186.0 163.1) Note: DERs were calculated for only 161 companies (out of 214) that had positive equity.0 193. Third.4) 18.2 23.0 1. the NPL ratio had reached more than 60 percent.0 111.0 205.271.0 72. Impact on the Banking Sector Table 1.0 635.5 percent in April 1998. from only 8. foreign exchange losses came about with the use of unhedged foreign debt.0) 10.1 (124.5 8. Second. losses in operation were due to declines in sales and increases in the cost of imported inputs.0 307. small foreign banks enjoyed the highest profits.0 108.0 2.
2 8.24 15. private national banks overtook State-owned banks when their NPL ratio jumped to 57.3 445.7 4.Chapter 1: Indonesia 41 Table 1.12 15. July No.0 129.2 — 19.06 20. Source: The National Banking Association.09 (11.5 222.20 ROE of the Banking Sector.2 37.68 1996 1997 8.7 Item Total Loans Dec 1996 July 1997 Dec 1997 July 1998 NPLs Dec 1996 July 1997 Dec 1997 July 1998 NPL Ratio (%) Dec 1996 July 1997 Dec 1997 July 1998 Total 331.44 15.0 — 32.34 16.7 — = not available.70 1995 7.1 47.7 106.9 11.5 34.3 22.09 11.30 5.07 1994 14.24 (4.2 47. 230/1998.15 20.45 — 1993 15.0 622.21 Nonperforming Loans by Type of Bank.67 8. The high and increasing NPLs.37 19.2 10. .9 — 11. In July 1998. 1992 7. 1992-1997 (percent) Type of Bank State-Owned Banks Foreign Banks Joint Venture Banks Regional Development Banks Private National Banks Total — = not available.9 percent.4 7.1 1.5 128.73 30.20) Table 1.6 — 13.0 — 4.6 — 4.50 9.8 3.8 187.1 13.38) 11.45 21.3 361.47 20.8 11.89 27.84 27.5 57.91 21.69 14.1 198. State-owned banks initially had the highest NPL ratio.9 297.43 10. coupled with negative spreads (deposit rate was higher than the credit rate).1 274.5 31. however.2 — 8.9 Regional Foreign and Development Joint Venture Banks Banks — 9.7 — 1.07 13.81 13. Source: Infobank.8 14. put pressure on the banking sector.86 11.7 29. 1996-1998 (Rp trillion) State-Owned Banks — 140.72 16.5 2.2 48.6 6.1 30.28 5.25 22.8 8.39 13. 227/1998 and October No.6 — 1.2 8.3 Private National Banks — 179.2 1.
assembling the legal and policy framework to facilitate corporate restructuring. The scheme encourages negotiation between creditors and debtors. have been subject to restructuring deals under the initiative. a more comprehensive scheme to tackle domestic and foreign corporate debt. such as Garuda (a national flag carrier). In June 1998.7 percent ($64. Since September 1998. The scheme offered a hedging facility against rupiah devaluations for restructuring agreements. Corporate debt accounted for 46. the corporate sector had more than Rp600 trillion ($75 billion at Rp8. In addition.7 billion of foreign exchange debt. In November. II 1. and Ciputra (property business).4 trillion of domestic debt and $6. Another option that companies could take under the Jakarta Initiative was debt restructuring via debt-to-equity swaps. the Jakarta Initiative Task Force had conducted negotiations for 52 companies with Rp2.000 eligible firms had signed up for the scheme. the scheme failed. Unfortunately. Aside from being described as overly complicated.6 billion) of Indonesia’s total external debt in March 1998. More than two thirds of private debt was short-term and the average maturity of all private debt was estimated to be only 18 months. The committee was tasked to ascertain the level of private corporate sector debts and arrange negotiations between debtors and creditors. Semen Cibinong (cement industry) became the first Indonesian company to resume paying part (25 percent) of the interest on its $1.5. few companies were in a position to resume interest payments. particularly in terms of debt resolution. companies were not servicing their debts.42 Corporate Governance and Finance in East Asia. none of the 2. Vol. by mid-September 1998. the committee launched the Jakarta Initiative. only a . However. a number of prominent companies. the Government and private sector formed a committee to help corporates deal with the crisis. Total amortization payments due on foreign debt in 1998 were placed at $32 billion (before restructuring). about 80 percent of which was private. By end-November.3 Responses to the Crisis Corporate Restructuring Measures At the end of 1997.2 billion debt.000/$1) in debt from domestic commercial banks. IBRA was formed to offer Mexican-style resolution for private sector foreign debt. 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. Thus. On 9 September 1998. While the process of restructuring was in progress. Astra International (automotive).
Chapter 1: Indonesia 43 few companies reached agreement with their creditors on this. a publicly listed company operating in the automotive industry. Astra International (automotive industry) and Bakrie Brothers (a holding company in several sectors) explored this option. A Commercial Court was set up to handle corporate restructuring and debt settlements. Standard Chartered. Protection against insider and fraudulent transactions taken by a debtor prior to the adjudication of bankruptcy will be enhanced. Qualified professionals from the private sector will act as receivers and administrators in the management of estates of companies in bankruptcy or reorganization. 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. Bank Niaga also negotiated with some of its creditors. Rabobank and Citibank. for equity infusion. For instance.e. the companies’ financial performance deteriorated. with the requirement that adequate compensation and protection will be provided to such creditors during that period. and sell noncore businesses or nonoperating assets. Some listed companies with relatively “rich” shareholders decided to replace their loans with additional equity through rights issues and privileged subscription (limited offering). mining. especially in preventing unjustifiable delays in the adjudication of bankruptcy. forcing them to cut costs. focused on its core business of car and motorcycle manufacturing and sold off its subsidiaries in semiconductors. plantations. Bank Bali agreed on a debt-to-equity swap with its creditor. Astra International. Procedural rules are also being introduced to ensure certainty and transparency in the proceedings. i. 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). lay off workers. aiming to modernize the bankruptcy system and promote the fair and expeditious resolution of commercial disputes. Bankruptcy Reform The Bankruptcy Law was passed in August 1998. Moreover. Debtors. some companies attempted to restructure their businesses on their own. under which the latter would become one of the bank’s shareholders.. and mining equipment. consolidate business units. In the banking industry. as well as general commercial disputes. When credit from the banking sector became unavailable and interest rates increased significantly. The Commercial Court can be asked to hold off creditors and impose strict guidelines on the negotiating process . Meanwhile.
In the longer term. Rather. the Court’s early record has been a disappointment. collusion. (iv) measures to recover liquidity support previously extended to troubled banks by Bank Indonesia. the Government did not impose restrictions nor did it attempt to regulate capital flows.44 Corporate Governance and Finance in East Asia. There will be changes in the implementation of the bankruptcy law. Some companies simply decided not to pay their loans knowing that it would be difficult for creditors to take the case to court. Banking Sector Reforms The Government’s banking sector reform strategy is focused on (i) government-assisted recapitalization programs for potentially viable private banks. is also reviewing the Bankruptcy Law. The Government has also been concerned with the issue of capital controls. II to achieve liquidation of the company. it is envisaged that the Commercial Court will play a central role in modernizing the commercial legal system. Vol. and nepotism (anti-KNN) was signed in 1999. Previously. The Court has also declared only two companies bankrupt. companies were allowed to sell shares only by issuing stock rights. Realizing that they undermine investors’ confidence. since the market reflects the condition of the economy. To push bankruptcy reforms. and recapitalization of state banks. including procedures for handling operational issues and processing bankruptcy cases. in consultation with IMF and the World Bank. 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. The bias in favor of debtors has retarded the pace of corporate restructuring. reform. However. (ii) the resolution of nonviable private banks. the measure had only a minimal impact. (iii) the merger. . Capital Market Reform In the capital market. The Agency also allowed companies to buy back up to 10 percent of outstanding shares to improve the condition of the stock market. with only 17 cases filed as of November 1998. The significance of a sound bankruptcy system cannot be understated as it provides a backdrop for negotiations in the workout and restructuring process against which parties often gauge their legal rights. The Government. However. the Capital Market Supervisory Agency allows companies to offer additional shares directly to the public. and (v) a strengthened banking supervision system. legislation against corruption.
Parliament approved amendments to the banking law that were geared toward strengthening the legal powers of IBRA and its AMU. and Recommendations Summary and Conclusions Corporate Ownership and Structure Most of Indonesia’s top conglomerates were established as family businesses. merged. It has also drafted regulations to remove obstacles for converting debt to equity. it is doubtful whether pure holding companies are able to enter into swaps. was enacted in 1999. the Government established IBRA to supervise problem banks. Bank Indonesia has announced a recapitalization program for potentially viable private banks.1 Summary. Conclusions. BBD. A new central banking law. The four state banks (BDN. and follow-up action on bank restructuring. the Government required banks to be audited by international external auditors. In October 1998. The merger process will be finished within two years. or sold (after transferring NPLs to the AMU). The Company Law at present can be interpreted as severely limiting the scope for debt-equity swaps. Banks deemed ineligible for recapitalization will be closed. Some 175 groups that originated from family businesses controlled . 1.6 1. In particular. Liquidity support given to troubled banks should be repaid in four years. improvement of rules and prudential regulations. To overcome these problems.6. The agency set up an Asset Management Unit (AMU) to directly manage problem loans of banks under its supervision. the Government has drafted a regulation providing tax neutrality for mergers and removing other tax disincentives for restructuring. providing Bank Indonesia with substantially enhanced autonomy. depositors will be fully protected by the Government. Other Regulatory Reforms To push corporate restructuring further. regulations will need to be issued to permit debt-toequity swaps in the context of corporate restructuring plans. The importance of this legislation may need to be emphasized. and Bapindo) will be merged into one bank named Bank Mandiri. To obtain a clearer picture of the banking sector. The Bank Indonesia 21st package includes recapitalization. BEII. However.Chapter 1: Indonesia 45 In 1997.
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. not all of the conglomerate-affiliated companies are publicly listed. Vol. banks were unwilling to provide credit to highly leveraged companies. conglomerates set up their own banks to serve as “cashiers” providing credit to companies within groups. when barriers to entry in the banking sector were lifted. As a result. When the Government regulated the legal lending limit and the net open position of banks. conglomerates set up finance companies to bring in cheap foreign loans as these companies were not adequately regulated. However.6 percent of the total stock market capitalization in 1996 and the top 15 families controlled 61. thus. families control 67. lacked the information necessary to allow them to assess projects’ risks and chances for success.7 percent. Among those listed in the Jakarta Stock Exchange. corporate debts grew over time. The free capital flow system permitted the inflow of foreign capital to fuel the credit boom in the economy. the majority remains family-controlled.46 Corporate Governance and Finance in East Asia. But because foreign creditors were reluctant to lend long term. The financial crisis created opportunities for addressing the inefficiencies in the legal and judicial system that supported corruption. This study reveals that Indonesian listed companies with higher ownership concentration had higher levels of leverage. retain ownership control of companies. Rapid growth in investments masked the corporate sector’s increasing leverage. this financing pattern supports the claim that family-based controlling shareholders relied on excessive borrowing to finance corporate expansion . II 53 percent of total assets of the top 300 Indonesian conglomerates. The restructuring and resolution of financial distress may. however. These banks also obtained cheap offshore funds. Foreign creditors. put a significant amount of corporate assets of conglomerates in the hands of creditors or the Government.1 percent of publicly listed companies in Indonesia. Financing Patterns Controlling shareholders opted to use debts to finance expansion. allowing them to maintain their equity shares and. On average. while a single family controlled 16. However. meanwhile. Indonesian companies borrowed short term. Therefore. Companies relied heavily on bank credit. These figures show the extent of power wielded over the corporate sector by a small number of families. On the one hand.
When the crisis hit Indonesia. NPLs rose and capital adequacy ratios fell.1 percent in 1998.Chapter 1: Indonesia 47 without diluting their control. The problem was in the maturity structure of its dollar-denominated debt and high debt-to-equity ratios in some sectors. corporate-initiated debt restructuring . The significant increases in leverage indicate a rapid rise in the rupiah value of debts due to the revaluation of dollar-denominated debts. the consumer goods industry was the worst hit. and the rapid decline in equity due to losses. Bank Indonesia extended emergency loans to many banks.1 percent in 1997 to -124. were the most adversely affected. particularly those with large short-term foreign loans.21 trillion in 1996. although at a declining rate. the corporate sector was in quite good shape in terms of growth and profitability. The Government introduced reforms to improve bankruptcy procedures.24 trillion in the first half of 1998. The financial crisis led to the closure of several dozen banks. Responses to the Crisis The impact of the financial crisis on the corporate sector was serious. Sales of conglomerates as well as those of publicly listed companies were increasing. Impact of the Financial Crisis Prior to the crisis. facilitate debt restructuring.370 percent in 1998. followed by the property sector.1 trillion in 1997 from Rp13. ROE dropped from 1. Meanwhile. the highly leveraged companies. financed by issuing nearly $80 billion worth of bank restructuring bonds. the Government initiated corporate debt restructuring measures (Mexican-style foreign debt resolution and the Jakarta Initiative). the high domestic interest rates that prevailed from 1998. and strengthen prudential regulations and supervision of the financial sector. Net profits of publicly listed companies had consistently been growing at an average rate of 20 percent each year. To restructure the corporate sector. The Government and the private sector responded with measures to mitigate the negative effects. Total profits of publicly listed companies dropped to Rp3. On the other hand. it also reflects the failure of the financial sector to channel funds to the corporate sector efficiently due to weak prudential regulation and supervision. At the height of the crisis. and registered a net loss of Rp39. DER increased to 307 percent in 1997 and further surged to 1. As the rupiah weakened and interest rates increased.
48 Corporate Governance and Finance in East Asia. II measures included internal business restructuring (e. 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. but it is not clear whether in practice these standards are in place. cost cutting and business consolidation) and acquisitions by creditors or foreign investors through debt-to-equity swaps and equity infusions. 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. Improving the Legal and Regulatory Framework for Bank Supervision After the liberalization of the financial sector.2 Policy Recommendations The Government should introduce measures to address the weaknesses in corporate governance identified in this study.6. The Corporate Law should be reviewed and amended in the context of pervasive control by large shareholders.g. The Government should ensure that all laws and regulations are effectively enforced. Specific recommendations include protecting the rights of minority shareholders. the regulatory environment was not prepared to supervise the increasing number of banks and nonbank . the legal system is less likely to evolve in a manner that will allow it to protect minority shareholders. Protecting Minority Shareholders’ Rights The Corporate Law provides sufficient rights and protection for all shareholders.. but inadequate protection to minority shareholders from the dominance of large shareholders. Most companies claim to have adopted international standards of accounting and auditing procedures. Vol. 1. improving the legal and regulatory framework for bank supervision. (ii) delineating the functions of the board of directors and commissioners. and (iii) strengthening transparency and disclosure requirements. and protecting creditors’ rights. In particular. minority shareholders have not been able to oppose controlling shareholders’ decisions to invest in unprofitable projects financed by unhedged foreign currency debts.
the Republic of Korea and Thailand were more successful in getting foreign creditors to collectively solve their problems during the crisis. it has been difficult to implement standstills. the Government lost monitoring and control powers over foreign fund flows. When finance companies were used to channel offshore loans in lieu of commercial banks.Chapter 1: Indonesia 49 financial institutions. and liquidation of corporate assets. One way is to set limits on lending activities by banks to affiliated nonfinancial companies. a new bankruptcy law was passed in the aftermath of the crisis and a Commercial Court was set up to deal with bankruptcy cases. the Indonesian corporate sector directly owes an inordinate amount and a greater portion of its loans to foreign banks. the banking regulatory framework was inadequate in regulating banks’ dealings with affiliated nonfinancial companies. Further. orderly restructuring. The Government should also continue strengthening the monitoring system for foreign exchange transactions. In the first place. recapitalization. it is likely that future private financial flows for the corporate sector will continue to conform to a short-term structure. Banks should be required to provide data on such transactions and charged penalties for noncompliance. However. 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. Protecting Creditors’ Rights To protect creditors’ rights. the Court has been slow and ineffective in processing bankruptcy suits. Because foreign creditors are faced with more information asymmetries than domestic creditors. The ownership of banks (including finance companies) by shareholders of nonfinancial companies undermined the capability of these banks to conduct prudential credit management. Because these banks are neither easily convinced nor compelled to submit their claims to the jurisdiction of Indonesian commercial and bankruptcy courts. with necessary legal sanctions for violations. With credit being coursed through the domestic banking system rather than directly to numerous local corporations. This is a significant factor in . in contrast to the Republic of Korea and Thailand. The Central Bank needs to monitor and control dealings by banks within business groups and improve enforcement methods to prevent circumvention of prudential regulations. Consequently. The tendency of foreign creditors to lend short term is a problem that must be confronted once private capital flows to Indonesia recover.
despite the smaller level of capital inflows (as a percentage of GDP). Only when creditors have the confidence that their rights are protected will they resume financing companies.50 Corporate Governance and Finance in East Asia. II explaining the greater depth of the crisis in Indonesia. 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. Vol. .
. 1998. 1996. Claessens. . Asia in Crisis: The Implosion of the Banking and Finance System. Indonesian Business Data Centre. University of Maryland. Conglomeration Indonesia: Regeneration and Transformation into World Class Corporate Entities. JSX Monthly Statistics. The Economist Intelligence Unit. Economy of Indonesia. The Economist Intelligence Unit. Indonesia Country Report. Wright. Working Paper #58. various publications. and M. Lang. Economic and Financial Statistics. Simeon Djankov. 1995. Financial Sector Practice Department. Bank Indonesia.Chapter 1: Indonesia 51 References ADB Programs Department (East). Institute for Economic and Financial Research. John Wiley and Sons. Maryland. Yogyakarta. Large and Medium Manufacturing Statistics. The Private Debt Anatomy. 1999. Indonesia: An Emerging Market. Unpublished thesis MMUGM. Keasey. Risks. F. 1996. Manuscript. Corporate Governance: Responsibilities. Indonesian Central Bureau of Statistics. 1997. P. Jakarta Stock Exchange. Embassy of Indonesia Homepage. various publications. 1997. Who Controls East Asian Corporations? Financial Economics Unit. 1999. Indonesia Country Profile. Conny Tjandra Rahardja. 14 May 1999. Indonesian Business Data Centre. World Bank. 1998. 1995. K. P. and Richard Turtil. Indonesian Capital Market Directory 1992-1998. Center for International Business Education and Research. Michael Krill. various publications. The Impact of Acquisition to Shareholders Wealth: Comparison Between Internal and External Acquisition. Forest. Letter of Intent of the Government of Indonesia to the IMF. Delhaise. various publications. and Remuneration. Jonathan. Embassy of Indonesia. John Wiley and Sons. Indonesia: Sustaining Manufactured Export Growth. and Larry H. Stijn.
the Republic of Korea. Poor corporate governance and political and government intervention in the business and financial sectors are widely viewed as contributory factors. As the Korean currency. 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. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. 1 Professors. Chung and Yen Kyun Wang1 2. the Government and business sector had good reason to reflect on the causes of the crisis. Business managers and controlling shareholders were maximizing firm size at the expense of profits. Department of Economics.2 Republic of Korea Kwang S. David Edwards. internal control mechanisms. It had been the norm in Korea to conduct business based on political and administrative favoritism rather than on competitive merits.1). and corporates were sent reeling. and Graham Dwyer for his editorial assistance. the Korea Stock Exchange for its help and support in conducting company surveys. Seoul. This has been the crux of the corporate governance problem in Korea. 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. both of ADB. a practice that was not checked by creditors.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 country’s winners would then emerge based only on economic efficiency. markets. 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. timely exit of poor performers from the market. Korea) in November of that year. and curtailing of morally hazardous behavior that has been prevalent among economic decision makers. or capital market discipline. . Inefficient investment coupled with excessive financial leverage was found to be at the root of the economic crisis at the corporate level. The authors wish to thank Juzhong Zhuang. Further. Chung-Ang University.
1 Listed Firms with Positive Economic Value Added. accountability of controlling shareholders and boards of directors.1 1998 490 164 33. . and improvement of bankruptcy procedures.54 Corporate Governance and Finance in East Asia.9 1994 531 165 31. capital market discipline. where NOPAT is the net operating profit after taxes and WACC is the weighted average cost of capital multiplied by invested capital. the corporate sector. and J Murrin (1995).1 1995 560 163 29.1 1996 561 163 29. June 1999. Copeland. The EVAs are the same as the economic profit as explained in T. This study also reviews the legal and 2 The survey was conducted mainly through the Korea Stock Exchange. Koller. This broad perspective can help clarify the ongoing reform efforts of businesses and the Government. which distributed and collected the questionnaire. Vol. Weaknesses in the overall corporate governance system in Korea had many ramifications. This study collects and analyzes data on the Korean economy.5 Note: The EVAs are calculated as: EVA = NOPAT – WACC. T. aiming to identify the areas in need of further reform and to provide policy recommendations for improved corporate governance. Inefficient investment undermined the competitiveness of Korean firms in the global marketplace. II Table 2. and individual companies. Dividend payments were at less than 2 percent annually as opposed to the double-digit interest rates in the past decades.4 1993 513 174 33. Many firms left some questions unanswered. especially chaebols. Self-dealings by controlling shareholders—crosssubsidization and cross-guarantees among member firms within a chaebol (a conglomerate/large business group)—and the lack of transparency hindered the development of an efficient capital market capable of mobilizing low-cost equity funds. Restructuring efforts have focused on reduction in the degree of business diversification and in the financial leverage of large-sized firms. Source: Korea Stock Exchange. 1992-1998 Item Total Number of Firms Firms with Positive EVA Percentage of Firms with Positive EVA 1992 508 180 35. Government reform goals for the corporate sector include enhancement of corporate transparency. A survey was conducted for the nonfinancial listed companies using a questionnaire developed by the Asian Development Bank (ADB)2 to supplement official data.1 1997 518 104 20. The total number of respondents was 81 out of about 550 nonfinancial firms listed on the Exchange.
and Yim (1998). reviewing government policies responsible for the development of the modern corporate sector. 3 The review of historical development of the Korean economy draws substantially from the book by Sohn. clothing.4 contains analyses of corporate financing and its relationship to performance. It reviews such elements as shareholders’ rights. Section 2. and employees and their role in shaping corporate governance practices. Section 2. Major economic indicators for some of these periods are shown in Table 2. corporate control by the Government.3 identifies characteristics of corporate governance by analyzing the ownership structures and control patterns of listed companies and the largest chaebols.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. . creditors. In the period 19481961.2. This chapter is composed of six sections. Section 2. and naturally adopted an import substitution policy. The evolution of the modern Korean economy can be divided into four periods. It then presents recommendations for further reform in corporate governance and financing.2. The Government tried to produce food.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. and other necessities domestically.2 2.2 presents an overview of the corporate sector. Import Substitution: 1948-1961 The Korean War (1950-1953) devastated Korea’s industrial capacity. Section 2. the Government relied heavily on aid from the United States (US) and United Nations to alleviate poverty and high inflation. Section 2. From 1948 to 1961. which account for a substantial portion of the Korean economy. the board of directors system. Yang. It traces the country’s economic development. the import liberalization rate was below 7 percent and the average tariff rate was in the range of 25 to 30 percent.6 discusses responses of the Government and the business sector and explains in detail their reform and restructuring efforts.Chapter 2: Korea 55 regulatory framework for the corporate sector and reform measures taken after the crisis.
International Financial Statistics.0 27.6 11.1 percent with moderate rates of inflation and introduced a series of reform packages aimed at developing key industries.1 9. In the Plan.2 314. high unemployment and inflation.9 794. Economic Statistics Yearbook. b Refers to 1979. and inconsistent economic policies.2 1980-1989 8.2 757.4 29.2 30.102.2 32. lack of strong drive.2 452.9 — — 21.7 30.9) (7. The Government tried . and large current account deficits. II Table 2.1a 21. and implementing new budget and tax measures. the Government redirected the policy focus away from import substitution to an export-led manufacturing-based economy.8 24. the Government was not successful in solving the problems of slow growth. However.5 38. e For maturities of one year or more.8 15.1 29.1d 9.1 15. 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. d Refers to 1997. In 1961 it devalued the won from W65 to W130/dollar and announced its first Five-Year Economic Development Plan (1962-1966). Export Drive: 1962-1971 Between 1962 and 1971.4 (1. the Government called for an unprecedented average annual economic growth rate of 7.9) 1.4 10.7c 11.2 6.265.4 24.1 35. largely because of political instability. Source: Bank of Korea.7 14.4 29.949.2 Key Macroeconomic Indicators Annual Average (percent.56 Corporate Governance and Finance in East Asia. Vol.332. modernizing the industrial structure. This goal required very high savings and investment rates.5) (1. c Refers to 1989.5) 8.0) 492.4 1990-1997 7.8 (8.0 41.0) (297.5 250.9b 15.3 8.1 — = not available.2 31. IMF.447.8 (724.2 1.753. 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. a Refers to 1971.7 37.8 12.855.
2 billion in 1972. In 1963-1964.5 percent. the import liberalization rate was 55 percent. the Government undertook important economic reforms in two areas: the foreign exchange rate and the interest rate. the growth of gross domestic product (GDP) raised domestic savings. During this period. Exports increased sharply from $41 million in 1961 to $2. channeling funds from curb markets into the banking sector. but the average growth rate for 1965-1969 shot up to 10 percent. Bank deposits increased rapidly. boosting internal investment resources. and almost doubled the foreign exchange rate from W130/dollar to W256/dollar to enhance the international competitiveness of exports. a modest improvement over the 4. The exchange rate system was a kind of crawling peg until 1974. The Government abolished temporary direct subsidy measures and introduced a new comprehensive export promotion system. and maximizing mobilization of domestic savings on the other. This change raised the import liberalization rate from 9. but tariff rates were raised to 40 percent in the 1960s. resulting in high real interest rates. In 1965 the interest rate on one-year deposits doubled from 15 to 30 percent. imports of consumer goods and luxury items were highly restricted. However. In 1964. abundant. the Government tried to provide exporting firms with a free trade environment. 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. Also. which laid a solid foundation for a steady growth path. and cheap labor force was well utilized by the export-led growth strategy. Korea normalized political and economic relations with Japan to encourage inflows of Japanese capital that could finance big development projects.Chapter 2: Korea 57 to meet its targets by borrowing large amounts of foreign capital on the one hand. In 1971. But the liberalization trend turned out to be short lived as current account deficits continued. up from 30 percent in the late 1950s. The positive list system for imports was replaced with a negative list that indicated only those items that could not be imported. The well-educated.4 percent. . The average growth rate of the economy from 1960 to 1964 was 5. These were considerably liberalized in 1967 when Korea joined the General Agreement on Tariffs and Trade (GATT). while the average tariff rate was 39 percent. due to continuous current account deficits. During the first five-year plan period. the Government changed the multiple and fixed exchange rate system to a unitary floating exchange rate system.3 percent average between 1954 and 1959.3 percent to 60.
and allocating virtually unlimited amounts of credit at below-market rates while controlling the financial system. One industrial policy adopted during the heavy and chemical industrialization drive was administered credit rationing. shipbuilding. Unlike the previous system. in the face of a world economic slump. the domestic economy was stagnant and many businesses. The HCI promotion policy was much more comprehensive than past economic development plans. and chemicals—as future core industries. It promoted HCIs by supplying massive capital for construction and development. Second. and assigned them to specific chaebols.58 Corporate Governance and Finance in East Asia. These practices contained an implicit government guarantee that large businesses and banks could never fail. the Government felt that continuous trade deficits arising from increasing intermediate and capital goods imports could be prevented by developing import substitution industries. These included rescheduling business debts. This strategy formally took off with the announcement of the HCI Promotion Plan in June 1973. where preferential export credit was given to almost every exporter. announcing rescue packages for businesses and banks. In 1972. and giving low interest rate loans to banks from the central bank. The Government targeted six industries—steel. The Government took emergency measures. investing a total of $9. faced the danger of bankruptcy. it tried to substitute imports and export high value-added HCI products. nonferrous metal. Vol. becoming a seed of the economic crisis in 1997. Third. machinery (including automobiles).6 billion between 1973 and 1981 into these sectors. It included a detailed construction and investment schedule over a 10-year time frame and mandated coercive implementation. 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 . reducing or exempting debts of farmers and fishermen. The Government has since used similar emergency rescue measures for large businesses and banks almost once every 10 years. II Heavy and Chemical Industry Promotion: 1972-1979 In the Third Five-Year Economic Development Plan (1972-1976). less developed countries forced Korea to adjust its industrial structure. the Government felt the need to strengthen the defense industry. electronics. By promoting HCIs. The Government encouraged a variety of business projects. There were three reasons for the switch: first. the Government changed its industrial policy emphasis from light industries to heavy and chemical industries (HCIs). the emergence of competition of other low-wage. overburdened with debts and high interest rates.
Economic Liberalization and Globalization: 1980-1997 In 1979. coupled with political uncertainty due to the assassination of President Park in 1979. imports were further liberalized while tariff rates were lowered. Such an approach gave the Government increased control over the economy. a heavy foreign debt burden. met increased difficulty. Evaluations of HCI promotion policies are mixed. Korea recorded current account surpluses and rapid economic growth due to the “three lows”: low value of the US dollar. This required industrial restructuring by the Government. price controls were abolished. Meanwhile. fiscal expenditure maintained zero growth. Macroeconomic policies became hostages of the industrial strategy. Meanwhile. New start-up firms.Chapter 2: Korea 59 through state-controlled banks. and the won depreciated by 20 percent with the adoption of a Basket-Currency Gliding System in 1980. including forced liquidations and mergers and acquisitions (M&As). The incentives available became more market-based. The growth rate of the money supply was reduced drastically. the Government adopted comprehensive measures to promote economic stabilization. In order to improve economic efficiency. since during the second half of the1980s many of the promoted firms became world-class competitors and exporters. The plan of the 1970s was thought to be successful in the long run. as it had to control only a few large chaebols. the Government restructured some large businesses through forced liquidation and M&As. various measures to increase competition were taken. light manufacturing and service industries were weakened by disadvantages such as a lack of credit. faced with high inflation. with many turning into the now well-known chaebols. The severe world recession caused by the second oil shock. including denationalization of banks. In 1986-1989.2). However. The industrial and trade policy resulted in high inflation in the 1970s and serious excess capacity problems by 1979. the policy wasted substantial amounts of resources in the short and medium terms. Firms that followed the Government expanded greatly. exacerbated the overcapacity problem. low . however. such as widespread underutilization of capacities of HCIs and related plants. The two important ones were import liberalization and deregulation of the financial sector. Gross national product (GNP) growth rates on average were higher in the 1972-1979 compared to 1962-1971 (Table 2. and their utilization ratios were very high. and the large excess capacity of HCIs. especially between 1979 and 1985. Cheap credit and distorted prices resulted in overexpansion in the HCIs.
2 Rise of the Large Business Groups (Chaebols)4 The Korean Fair Trade Act defines a business group as “a group of companies. joined the Asia Pacific Economic Cooperation (APEC) Group in 1993. By joining the Organisation for Economic Co-operation and Development (OECD) in December 1996. The official rate fluctuated within a band. whose business activities are controlled by an identical person. . giving up its foreign exchange controls related to the current account.60 Corporate Governance and Finance in East Asia.9 percent.1 percent and average tariff rates 8.2. The Government tried to adjust economic policies and regulations to meet global standards.2 percent.9 percent. 2. total sales. the importance of chaebols was increasing. II world interest rates. 4.” A large-scale business group is called a chaebol. which gradually widened. Vol.1 percent. Korea became a signatory country to the International Monetary Fund (IMF) Article VIII. and total workforce. 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). the Government committed itself to further liberalization of the goods and capital markets. with the 30 largest in the total economy in 1997 standing as follows: value-added. 47. further increasing its pace of import liberalization. but it chose to liberalize gradually. and declaring that it would follow Article XI of GATT. The most important element characterizing chaebols is the concentration of ownership. 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. 45. Industrial and trade policies were modified to be consistent with WTO. total assets. In 1990. the import liberalization ratio reached 98.3 percent. where particular individuals and their family have de facto control of the management of all subsidiary companies of groups. 46. Meanwhile. and low oil prices. Korea abolished remaining direct subsidy systems for export activities as well as some traditionally managed trade systems. Korea adopted a market average exchange rate system. Korea began participating in many multilateral trade negotiations during the Uruguay Round. The low value of the dollar led to a low won and high yen. In 1988. In 1993.9 percent. 13. while continuous and large current account surpluses saved Korea from the foreign debt problem. total debts. and acceded to the World Trade Organization (WTO) in 1994.
.5 20. reaching 669 in 1996. after the financial crisis.3 shows that the number of subsidiaries of the 30 largest chaebols increased considerably since 1993. Subsidiary companies of chaebols are subject to “fleet-type management” in that they are controlled by the overall managerial system of chaebols. In the mid-1970s. Since the 1960s. Chaebols are also excessively diversified. However. From the standpoint of the Government. it was more effective to deal with a small number of companies to secure tangible outcomes. The Government provided subsidies. Table 2.3 Source: The Fair Trade Commission. and tax breaks to key industries to promote exports and industrial upgrading.1 20. 1993-1996 Year 1993 1994 1995 1996 No. chaebols that maintained a close relationship with the political authorities were able to grow fast. Table 2.3 Subsidiaries of the 30 Largest Chaebols. Chaebols have a history of substantial concentration of ownership. financial assistance.when the Government put a great deal of emphasis on development of the HCIs. the Korean Government has set the national goals of economic development and offered all kinds of support and incentives to achieve them. and they are aided and supported by one another. of Subsidiaries per Chaebol 20. the number of subsidiaries declined drastically due to corporate restructuring. of Subsidiaries 604 616 623 669 Average No. Large-scale companies owned by the Japanese were sold to individuals under preferential terms and later enjoyed a relatively favorable position for accumulating capital. This galvanized the fast growth of chaebols. In this sense.8 22. This policy contributed greatly to the expansion of chaebols. Important managerial decisions are made primarily by owners. One reason for this controlling power is inter-company shareholding among subsidiaries. large-scale businesses and chaebols were thought to be appropriate actors because they could meet the huge investment requirements of these industries. The Government provided financial and fiscal incentives to chaebols and trading companies with relatively abundant financial resources. the ownership and management of a chaebol’s subsidiaries are not separate. Since the Government controlled most business activities.Chapter 2: Korea 61 War II.
II Theoretically. Related to this is the tendency of chaebols to assist unprofitable firms at the expense of profitable ones. 2. internalization of the market that could enhance the internal efficiency of a chaebol may close the market to other firms. profitability.2. if a chaebol has an unsound financial structure but strong financial links through mutual payment guarantees among their subsidiaries. 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.3 Role of the Capital Market and Foreign Capital In the 1960s. etc. years since establishment. chaebols can benefit from synergies. Since chaebols are engaged in many different businesses.62 Corporate Governance and Finance in East Asia. Under this law. diversification can make chaebols stable through the portfolio effect. the Government reviewed the financial performance of companies and recommended (or ordered) selected ones to go public. On the other hand. Meanwhile. This could ensure their stable growth and enhance their investment abilities. However. in addition to the usual economies of scale. . They had to meet certain requirements in terms of firm size. there are many negative assessments of organizational structures and practices of chaebols. For example. and were allowed extra depreciation charges for tax purposes. the bankruptcy of one or a few marginal subsidiaries could lead to a chain of bankruptcies for the entire chaebol. The law also allowed employees of listed firms to get 20 percent of the subscription rights in offerings of new shares. 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. the Government’s efforts to develop the stock market culminated in the Capital Market Development Act of 1968. This law was in effect until 1987 when it was partly absorbed into the Capital Market Development Act. they can reduce uncertainties and dilute risks through sharing of information and diversification. which may ultimately lead to the decline of social efficiency. including the “economies of organizational size” inherent in multi-product and multiplant firms. Vol. Another law that contributed to the development of the stock market was the Act to Expedite the Going Public of Corporations of 1972. listed companies enjoyed corporate tax rates that were 10 to 20 percentage points lower than those imposed on privately held firms. In the early years after the enactment of the law.
217 141.1 Market Capitalization (W billion) 6.6 747.151 117. . First. the Government announced the gradual opening of the capital market to foreign investors in January 1981.5 406.6 Year 1985 1989 1990 1994 1995 1996 1997 1998 Source: Monthly Review (Securities Supervisory Board) and the Financial Supervisory Service. the Government announced measures to increase the demand for shares by providing tax and financial incentives to individual investors. a country fund. Second. the stock market grew rapidly during the 1980s. The policy to expand the size of the stock market. 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.1 16.4 40. mainly by increasing the supply of shares by initial public offerings (IPOs) and seasoned issues.4.2 44. several important policy measures were implemented to promote the development of the stock market.0 965. 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). Beginning 1990. in 1986 the Government imposed limits to bond issues on firms that were recommended to go public but refused. The aggregate Table 2. especially those paying small or no dividends.9 833. Inc. was established to invest in domestic shares beginning in September 1985.7 934.1 30.0 79. This reversal in policy reflected declining stock prices and was generally maintained until the outbreak of the economic crisis in 1997. however.370 70.. Because of government policies and the booming economy.Chapter 2: Korea 63 During the 1980s and 1990s.4 654.9 918.798 Market Capitalization as a Ratio to GDP (%) 8. Also that year. In this regard.4 Development of the Stock Market. Third.020 151. As shown in Table 2. continued until 1989.989 137. 1985-1998 No. of Listed Firms 342 626 669 699 721 760 776 748 Stock Price Index 138.476 79.570 95.9 34. the Government attempted to stabilize the stock market by limiting IPOs and share issues by listed companies.0 49. The Korea Fund.
571 2.542) (1.910) 2.326 1.694) 2.59 percent in 1998 and to more than 50 percent in the early months of 1999.64 Corporate Governance and Finance in East Asia.339) (9.413) 56.287 (340) 73. but rose again to 34.5 shows net FDI—inward investments by foreigners less outward investments by Koreans—in the period 1985-1998. II market value of all listed firms represented only 8 percent of GDP in 1985. foreign direct investment (FDI) has been very small relative to GDP and compared to other East Asian countries.382 Permit basis.414) 5. However.944) 8.737 (333) (297) (607) (2) 218 2.942) 42.852) (2.86 percent of GDP in 1997.085 2.868 (518) (418) 63 1.953 10. Source: Balance of Payments.875 21.583 25 10.149 13.500 7. Korean companies borrowed substantial amounts of foreign capital due to the excess of investments over savings and chronic current account deficits—except in the period 1986-1989. The aggregate market value of listed shares bottomed at 16.183 12.546 (2.2 percent by 1989. The number shrank for the first time in 1998 to 748 firms from 776 the previous year. Other investments include loans.658) (3. and 1993.453 (2.150 5.642 21.126 (1.785 (1.141 4.255 2.870) (1. 1985-1998 ($ million) Year Net FDIa Portfolio Investments Other Investmentsb Of Which Loans Trade Credits 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total a b 313 (9) 696 809 147 (808) (115) (311) (832) (2.001 4.553 8.534) 1. but increased sharply to 79.433) (9. and stayed at the 30-40 percent level up to 1996.858 4.800 (7.742 (3.440 1.123 3. Table 2. The growth in the number of listed firms also slowed in the 1990s.347 3.714 1.239 19.008) (3. Vol. Table 2.352 471 3. and other liabilities.650 (1. The relative size of the stock market diminished to 44 percent in 1990. currency and deposits.450 24.264) (3. due to declining stock prices.338 4.924 (1. Bank of Korea. .817 16.455) 13. The reasons for the decline include increases in bankruptcies and mergers involving listed companies since the outbreak of the economic crisis.296) (6.5 Private Capital Flows to Korea. trade credits.017) 1.
weak incentives for attracting FDI. portfolio investments amounted to $73. and sales of the aggregate sector during this period were very high (Table 2.7 billion and loans $42. The debt-to-equity ratio (DER) averaged 311 percent for the period 1990-1996 and peaked at 424. This would lay the foundation for evaluating the effect of corporate governance on performance.China and the US. increased substantially in 1994-1996 due to accelerated liberalization of capital movements (Table 2. The same categories will be analyzed in later sections. The growth rates of total assets. following the sharp depreciation of the won. (ii) listed firms.2.5).Chapter 2: Korea 65 Complicated government regulations.9 billion. Of this. and high production costs were the main reasons for low FDI in Korea.6). other net private capital inflows amounted to $130 billion during 1985-1998.2 percent in 1987. Profit rates of Korean firms were relatively low compared to those of Taipei. but between 1988 and 1993. Japan’s was consistently higher. However. and (iii) chaebols. equity. excluding FDI.4 Growth and Financial Performance This section looks at the performance of (i) the aggregate corporate sector. Taipei. Return on equity (ROE) and return on assets (ROA) showed similar patterns. the growth rates of equity and sales dropped sharply in 1996 and 1997. Corporate sector net proft margins increased from 1993 to 1995. Korea had substantial current account surpluses and experienced net private capital outflow. Large amounts of outward investment by Koreans in the mid-1990s arose out of increased liberalization of foreign exchange regulations. The contribution of the corporate sector to GDP was 73. The dismal performance of the Korean corporate sector compared to the . The ratio is generally in the same range for Japan and Korea. but dropped in 1996 and were negative by 1997. increasing to 76 percent in 1997. This indicates that a substantial proportion of debt was denominated in dollars. Table 2.7 compares the ratio of ordinary income to sales of Korea’s manufacturing sector with those of Japan. Between 1986 and 1989. and US. In addition to FDI.China. Net private capital inflow. 2.6 percent in 1997. The Aggregate Corporate Sector The aggregate corporate sector in this study excludes the financial sector.
Source: Bank of Korea.3 335.0 (0.5 4.9 16.3 1.0 10.1 6.8 1.2 1.0 13.9 13.7 3.1 5.0 7.1 2.9 2. Note: Ratio of ordinary income to sales = (ordinary income/sales).0 3.Table 2.9 4.0 305.0 6.5 1.7 3.6 13.6 3.4 2. Source: Bank of Korea. Ordinary income = operating income + nonoperating income (from financial activities) – nonoperating expenses (from financial activities).6 4.5 2.9 5.0 8.2) (0.1 8.6 2. 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 23.9 5. Financial Statement Analysis Yearbook.9 8.2 9.7 325.4 1.2 19.0 4.7 15.4 19.5 3.3 6.5 1.2 13.9 5.8 22. Net profit margin = ratio of net income to sales.7 4.8 1.8 8.China 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 2.3) 5.7 International Comparison of Ratios of Ordinary Income to Sales in Manufacturing (percent) Year Korea US Japan Taipei.6 424.9 3.3 14.4 2.2 1.5 1. Table 2.4 2.3 11.4 1.3 21.3 — 3.9) DER = debt-to-equity ratio.5 0.6 1.7 15.3 312.0 0.5 4. ROA = return on assets (ratio of net income to total assets).9 2.7 2. .4 — 6.8 3.9 3.9 16.3 21.6 9.7 4.7 1.3 308.4 4.2 18.7 4.0 13.1 2. Financial Statement Analysis Yearbook.2 13. ROE = return on equity (ratio of net income to stockholders’ equity).4 10.9 18.4 1.6 318.2 1.1 — — — = not available.5 7.3 17.5 (0.3 3.9 18.8 2.8 21.6 1.8) 297.9 2.1 2.6 Growth and Financial Performance of the Nonfinancial Corporate Sector.6 (4.
This may be related to its having the lowest DER. followed by mediumsized firms and large ones. this may be an indication of the bias toward large firms in terms of access to credit. the exception being the electricity.10). The profit margin of listed firms was generally higher than that of the aggregate corporate sector. The manufacturing. Again. with equity in wholesale and retail trade even contracting. Performance followed similar patterns across different industries (Table 2. Profit rates of most industries are also quite low. All sectors experienced a sharp decline in equity and sales growth in 1997.and small-scale firms (Table 2. while their average net profit margin was lower than that of medium firms. construction. Net profit margins. The other financial ratios follow the general pattern of the aggregate corporate sector. and ROAs of all listed firms declined substantially in 1996 and turned negative in 1997. sales of listed firms grew 18. . However. However. Listed Companies The number of listed firms increased from 334 in 1985 to 775 in 1997 (Table 2. ROEs.Chapter 2: Korea 67 other three economies can be attributed to the emphasis on growth in sales and market shares rather than on profits. with the wholesale and retail trade sector and the construction sector having the highest figures. In 1997. and transport sectors recorded negative profit rates in 1997. trade. In most years.5 percent while the aggregate sector recorded only 13. both ROA and ROE were lower for the listed firms compared to the latter. This preference of Korean firms has its roots in the structure of corporate governance.6). It is notable that the construction sector’s profit rate began its decline in 1995. Profit rates of different industries also mirrored the downward trend of the aggregate corporate sector prior to the crisis. and steam supply industry. the sales growth of listed firms was higher than that of the aggregate sector (see Table 2.8).4 percent. the average ROE was lowest for large firms. gas. a year ahead of the other industries. Growth rates of total assets are generally high. but higher than that of small firms. Small listed firms were hardest hit by the financial crisis. The growth performance of large firms for the 1988-1997 period was better than that of medium. A comparison of performance by firm size reveals some interesting results.9). 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.
6 3.5 30.0 (0.8 526.4 2.7) 2.7 22.2 15.9) 1.8 23.1 27.0 254.8 10.5 6.7 7.6 6.9 (0.8 14.6 14.7 520.0 1.9 1.6 12.2 16.9 (0.0 2.Table 2.7 1.0 16.3 8.4 2.7 10.2 25.6 15.2) (0.8 16.0 9.0) 0.8 3.4 (0.3 1.2 18.2) 6.5 483.1 22.1) 3.5 6.4 348.9 5.9 13.3 288.0 22.7 9.4 10.7 (3.6 5.6 375.8 14.0 (0.1 1.3 18.4 0.2 (1.4 5.4 2.2 315.8 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 13.8 7.3 14.0) 1.6 17.8 32.5 5.0 1.5 1.9 19.8 0.0 12.4 291.9 538.6 318.0) 4.3 8.4 458.4 10.0 18.6 24.7 30.7 228.7 0.8 16.5 239.3 10.0 5.8 Real Estate.4) 0.1) (3.6 11.0 22.0 21.1 (0.5 (0.1 21.6 7.8 2.5 286.1 0.8 24.7 5.2 7.4 17.2 20.2 20.8 1.2 0.8 13.8 22.5 473.3 285.1 2.4 10.5 28.2) 15.6 16.3 8.8 2.5 13.2 5.3 15.8 24.1 396.3 2.1 290.6 2.2 36.1 1.3) (1.0 15.8 616.5 14.5 5.2 6.0 18.7 17.1 0.6 655.5 1.6 1.2 24.8 0.2 241.5 306.7 (0.3 8.4 4.0 1.9 10.3 14.1 16.8 3.9 0.0) 0.0 1.0 3.0 22.8 2.5 16.6 14.1 10.4 14.3 15.1 7.6) 3.8) 0.4 5.4 5.1 1.4 350.2 2.0 15.9 16.4 1.6 12.1 2.4 15.9 2.3 10.8 17.3 2.9 428. and Business Activities 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 11.5 27.1 28.1 296.4 2.6 14.5 1.0 (4.0 1.2 423.9 2.8 302.8 22.7 21.0 23.6) (6.2 16.1 1.8 12.8 1.1 (0.3 15.7 16.3 1.4 0.0 2.0 19.5 569.5 1.7 514.3 15.6 17.6 0.9 340.6 3.0 24.5 1.4 12.8 461.9 29.6 0.9 25.9 10.5 (5.3 11.0 2.4 474.4 .2 5.9 9.5 (1.7 4.0 2.4 3.0 7.5) 0.5 23.0 37.0 1.0 1.5 Construction 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 18.0 5.7 317.4 10.5 270.1 0.8 35.9 31.5 19.2 12.4 740.5 4.3 13.0 24.0 16. Renting.1 17.9 14.0 245.9 16.3 25.9 3.5 432.9 (0.6 1.1 20.3 11.2 0.8 34.8 562.7 294.2 0.4 9.2) 22.8 345.4 2.4 1.5 1.8 12.5 3.8 10.5 338.3 31.2 6.8 16.1) 0.2 5.9 16.
7 0.7 11.6 — — — — — 0.3) 11.3 19.4 0.6 (2.3) (1.6 19.4 1.6 21.0 (1.0 Transport.6 9.4 2.4 12.3) 4.1) 5.9 321.3 125.9 Electricity.7 0.0 2.1 17.7 510.7) 0.2 2.4 10.5 539.4) (1.2 698.1 12.3 8.3 543. Storage.0 14.6 9.9 1.5 47.9 3. and Communication 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 15.0 2.3 112.6 12.1 15.1 16.7 7.6 20.2) 13. Gas.6 8.4 30.1) 1.5 26.8 6.3 4.5 14.5 2.5 462.7 11.2) 0. b NPM denotes net profit margin.5) 22.6 9.4 1.3 1.8 7.6 19.4 11.1 3.6 18.9 9.5 11.0 89.2 18.5 4.7 15.6 15.2 1.7 — — — — — 14.6 34.5 8.4 16.8 15.9 10.1 (0.6 6.1) (0.3 4.8 0.8 529.7 7.8 14.1 11.1 11.6 3.2 15.6 6.5 13.0 7.3 8.0 106.3 3.1 6.9 4.8 12.8 111.0 21.8) 1.4 3.0 5.3 — — — — — 10.8 11.1 21.9 (11.9) (8. Source: Calculated using data from Bank of Korea.8) (12.4 0.1 14.9 17.6 0.4 341.0 (15.2 90.3 2.0) 1.6 12.6 (2.1 15.7) (4.3 0.Table 2.6 4.7 19.3 17.1 323.3 12.7 20.2 18.3 740.5 344.8 (Cont’d) Growth Performance Year Assets Equitya Sales NPMb Financial Performance DER ROE ROA Wholesale/Retail Trade 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average — — — — — 31.5 (2.5 117.2 14.2 122.0 14.0 921.9 8.2 18.9 18.2 14.5 307.6 8.5 15.9 18.5 14.5 14.8 9.9 8.3 34.8 0.4 12.2 3.9 10.3 (2.2 10.1 4.4 6.3 23.1 1.3 1.4 14.6 4.5 16.5 15.4 2.6 1.0) 1.0 1.2) 9.4 — — — — — 448.2 143.7 2.6 8.4 13.6 1.3 18.2 10.4 6.8 14.5 0.4 3.6 172.3 9.9 9.5 14.062.7 187.8 3.1 (11.5 482.8 6.1 15.6 512.3 18.8 3.6 6.4 1.4 3.7 116.0 98.9 6.0) (0.7 2.1) (0.0 1.5 11.2 — — — — — 2.5 12.0 13. and Steam Supply 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 12.2 11.8 12.3 524.7 16.8 8.4 169.4 7. .7 12. Financial Statement Analysis Yearbooks.2 10.4 633.1 2.9 12.6 2.4 367.1 8.6 16.4 7.9 17.4 21.7 14.4 0. a New equity does not include capital surplus.9 4.9 (10.3 0.2 7.9 12.0 5.4 9.5 30.6 — — — — — 17.3 4.1 (2.0 1.3) 15.4 (0.5 612.9 332.9 456.8 4.6 14.9 7.4 15.7 11.7 — = not available.4 (2.
of Firms 334 351 386 503 626 669 680 681 687 698 715 754 775 Sales Growth 10.4) 1. The smallest group had 16 members in 1995.6 2.9 11.6 3. Performance of Chaebols This section uses available data on the top 30 chaebols.6 1.2 9.6 (1.6 0.9 6.5 0.5 19.1 1. the 30 largest chaebols accounted for 13. In 1997. Vol.1 6.8 0. the largest chaebol. It should also be noted that when the financial crisis struck in 1997.3 15.9 26.12).8 6.4 1.9 0.2 9.12).2 2.6 23. II Table 2.9 percent). had 46 member companies. of which four were listed.1 percent of the economy’s total value added (excluding the financial sector).2 6.0 3.9 Growth and Financial Performance of Listed Companies.2 0.4 2.4 0. sales (45.8 5.7 Net Profit Margin 0. and net profits (46.9 2.7 1.7 percent) of the corporate sector.9 21.0 18. Hyundai Group.6 22. Between 1993 and 1997.5 5. Chaebols have been the most important actors and engines of growth in the Korean economy. unless otherwise indicated) Financial Performance Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average No.3 20.6 and 2. but the number of designated groups has been fixed at 30 since 1993. 1985-1997 (percent.5 ROA 0.1 1.9 2. the growth of sales of the top 30 chaebols exceeded that of the aggregate corporate sector (compare Tables 2. and close to half of total assets (46.9 percent).3 4. The top five chaebols registered the highest growth rates.7 1.8 24.3 2.9 1.11).5 19.5 ROE 3.70 Corporate Governance and Finance in East Asia. followed by the top 6-10 (Table 2.4 1.3 0.7) 0.9 Source: Constructed using data from Korea Investors Service.3 percent).7 (5.4 1.0 0. The number of Hyundai member companies rose to 57 in 1997. of which 16 were publicly listed (Table 2.1) 4. debts (47. it is the chaebols’ large firms that are listed. Generally. In 1995. the top 11-30 chaebols experienced a decline of .4 22. The criteria for selection of largest chaebols have changed a few times.3 (0. 1998. Kis-Fas.
9 0.6 0.0) 1.5 Net Profit Margin Year Large Medium Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 2.3 1.6 0.2 13.6 3.8 16.0 1.9 25.3 Medium 14.0 16.9 1.8 7.7 (1.1 1.1 2.8) 6.2 3.2 1.8 0.9 2.4 3.2 2.5 2.3 9.2 0.8 1.7 4.3 15.1 0.5 (1.8 3.8 6.4 5. Kis-Fas.2 Note: Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.7 18.8 0.2 13.4 Medium Small Large Medium Small ROA Growth Performance Large 17.8 10.0 6.0 4.5 17.4 2.9 (0.6 1.7 1.2) (1.0) 0.9 0.5 5.1) 5.3 15. 1988-1997 (percent) ROE Large 9.9 14.6 9.8 (5.6 3.5 3.0 15.6 5.3) 5.9 6.5) 1.5 0.2) (1.2 2.4 16.9 6.2) 0.6 2.4 6.1 11.9 1.8 17. Source: Korea Investors Service.9 2.2 7.1 8.6 7.7 (1.8) 1.9) (6.5 25.3 (0.4 3.0 17.0 (4.3) 0.1 2.4 1.5) 1.2 (0.6) 0.10 Growth and Financial Performance of Listed Companies by Size.6 1.8 0.3 6.9 2.2 10.0 10.0 1. 1998.5 5.7 2.3 3.7 2.3 (0.7 (0.6 (1.6 (0.4 1.6 6.6 1. Others are medium firms.8 6.4 11.6 2.6 2.0 1. .2 12.8 0.5 1.9 22.4) 1.0 1.2 Small 13.3 11.9 0.9 3.Table 2.7 3.6 13.6 8.0 19.9 5.
924 2. .927 16.433 3.090 6.147 5.458 6.313 14.177 — 6.501 13.853 1997 53. 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.486 6.951 3.370 6.445 4.180 2.574 3.910 3.423 5.873 2.761 31.743 40.967 7.455 22.287 10.690 3.158 1.599 — 2.935 2.766 3.475 2.303 3.246 11.640 4.457 14.990 2.677 3.929 12.376 35.364 5.651 38. Source: Fair Trade Commission.346 3.597 351.117 4.427 9.996 1.798 — No.158 7.995 2.129 2.956 3.756 5. 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.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 43.774 7.Table 2.131 3.309 14.398 — 2.395 31.
6 (0.0 2.5 27.6 Financial Performance Net Profit Margin 1.8 0.1 (3.5) (0.9 1.1 (1.5) (0.2 0.1) (0. .3 3.3 11.7 15.8 27.3 9.5 5.4) (14.7) Source: Bank of Korea.3 1.1 (2.0) 12.6 1.12 Growth and Financial Performance of the 30 Largest Chaebols.2 (5.4 12.2 3.0 0.6 18.4) 1.2 (16.7 15.8 18.2) 1.4 30.2 (2.0 2.1 10.1) (1.0) 3.1) 0.9 20.9 17.1 19. 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 12.7 0.2) (2.6 19.0 17.7 1.9 24.3 0.3 14.4 26.1 2.0 19.5 20.5 32.5 (0.9 3.5) (0.4) (0.Table 2.1) (0.1 27.5 2.3 15.0 31.2 1.3 0.3 16.2 20.7) ROE 5.0 2.0 6.9 18.7 10.7 13.9 20.6 25.3 19.4 0.6 4.2 11.2) (0.2 (2.7 4.9 3.0 1.4 (2.2 0.4 38.8 Assets 12.2 0.3 27.0 0.7 10.3 1.3) 0.0) ROA 1.1) 0.5 19.
However. and led to a high concentration of ownership. Their worst year was 1997 when ROE hit -15.13). includes the largest shareholder.” in Korea’s legal and regulatory framework. The ROE of the top 30 chaebols was consistently higher than that of the aggregate corporate sector.765 percent (Table 2.3. his/her relatives. and government intervention interacted through a set of laws and regulations to bring about the existing structure. 5 While “ownership concentration” can be defined and measured differently in different contexts. loopholes and inconsistent policies spawned strategic behavior and agency problems.95 percent. Only the top five chaebols registered a positive net profit margin in 1997. Vol.3 Corporate Ownership and Control This section looks at the key aspects of corporate governance in Korea. resulted in the chaebols’ excessive leverage. chaebols had a higher average DER than the corporate sector as a whole. except for 1995. . a pyramidal structure of corporate ownership is prevalent. The absence of a well-developed equity market and the provision of subsidized credit.7 percent growth in total assets. coupled with weak corporate governance. and vulnerable balance sheets. and the companies that are under the control of the largest shareholder. There has been a wide range in DER among chaebols. II 2 percent in their sales and a very low 4.” This “identical person. it refers to the degree of concentration and shareholdings in the hands of an “identical person. 2. However. The Commercial Code stipulates the basic governance framework and applies to all corporations. and access to credit. the average DER of the 30 largest chaebols reached 519 percent. 2. By the end of 1997. 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. The better showing of the top five chaebols was a direct result of their dominance in human resources. more important. weak corporate control. internal and external control mechanisms. in this instance.5 Founding families are mostly still the largest shareholders and.1 Patterns of Corporate Ownership The ownership of most Korean listed firms is highly concentrated. technology. In general. Ownership patterns. the net profit margin of the aggregate sector exceeded that of the top 30 chaebols. The financial performance of the top 11-30 chaebols deteriorated during 1993-1997.74 Corporate Governance and Finance in East Asia. from 190 to 3.
Dongbu 24.Table 2.1 190.4 205.7 621.3 328.2 423. Hanwha 10. Dongkuk Steel 19. Haitai 26.7 354.2 328. Jinro Debt-to-Equity Ratio 376.0 436. Hanjin 8. Hanil 28. Halla 13.9 321. Lotte 11.5 2.5 337.8 313.0 486.3 297. Doosan 13.4 192.0 370. Kia 9. Samsung 3. Jinro 20.1 385.6 936.2 2.6 2.4 556. Daewoo 5.1 3. Hyosung 18. Samsung 3.6 . Kohap 25. Kumho 12.5 343.2 292. Tongyang 22.7 267. Kolon 21.764.1 674.9 751. Daelim 14. LG 4. Daewoo 5.441. Hansol 23.6 409.7 688. Hanjin 8. Hyundai 2.244. Sunkyung 6.5 464.0 506.2 924. 1995-1997 (percent) Chaebols 1995 1. Hanbo 15.1 477.5 3.2 346. Sammi 27. LG 4.8 336. Daelim 16. Halla 17.3 572. Dongah Construction 16.0 218. Lotte 11.5 383.13 The Top 30 Chaebols’ Debt-to-Equity Ratio.855. Dongkuk Steel 19. Byucksan 1996 1. Kumho 12.1 278.7 416. Hanwha 10. Ssangyong 7.6 516.3 315. Newcore 30. Hyosung 18.8 312. Hansol 17. Hyundai 2. Kukdong Construction 29. Dongah 14.2 471.065. Doosan 15. Ssangyong 7.4 175.4 622. Kia 9.7 620. Sunkyung 6.
bBank of Korea. Kolon 21.0 907.1 375. Dongah 11. Newcore 28.784.600.9 216.1 359. Hyosung 17.5 261.0 419. Hanwha 9.3 399. Miwon 30. Kamgwon Industrial 30.5 323.4 1.225. Hanil 28. Daewoo 4.8 468.5 1. Anam 22.5 576. Keopyong 29.6 478. Haitai 25.8 647. Doosan 15. Shinho 1997 1.1 438. Financial Statement Analysis Yearbook. Kohab 22. Saehan Average of All Chaebolsa 1995 1996 1997 Average of All Industries Excluding Financial Sectorb 1995 1996 1997 Debt-to-Equity Ratio 317. Dongbu 21.498. Dongkuk Steel 20.5 (893.7 370.1 433.7 944.8 307.8 658.8 338.8 347.6 Sources: aFair Trade Commission.9 578. Shinho 26.13 (Cont’d) Chaebols 20.6 335. Lotte 12. Halla 13. Hanjin 7.3 1. Kolon 19.9 1.9 472. Dongbu 23.7 1. . Hansol 16. Samsung 3.9 465.214.5) 404.0 505.8 399.4) 513. Tongyang 24. Keopyong 29. Anam 27. Tongyang 24.6 590. Daesang 27.Table 2. Kumho 10.6 416.3 676. Hyundai 2.5 (1.9 490. Jinro 23.0 305. Ssangyong 8. LG 5. Newcore 26.1 472. Daelim 14. Haitai 25. SK 6.6 424. Kohab 18.3 347.501.5 519.8 590.5 386.
large ownership can also bring about the entrenchment effect.” foreigners. with a given range of managerial shareholdings (for instance. the year the stock market was in a frenzy due to buying sprees. The next important group was “other corporations. the incentive effect once again dominates. The percentage of shares owned by “other corporations. 10 to 30 percent). Financial institutions owned as much as 28 percent of the total corporate shareholdings in 1992..” followed by banks.Chapter 2: Korea 77 When controlling shareholders hold a very small percentage of the shares. Most non-chaebol listed firms in Korea are believed to have ownership concentrations within the 10-30 percent range. Securities companies reduced their holdings over this period of falling stock prices as the size of investment trust companies’ stock portfolios declined.6 percent by 1997. including banks and other financial firms. individuals were also the largest shareholder group. the extent of ownership by these individuals declined gradually after 1988. Beyond that range. resorting to extensive use of pyramiding to maintain control. and state-owned companies and securities companies declined. the individual owners—the portfolio investors as well as the controlling shareholders and their family members—formed the largest shareholder group (Table 2. including investment trust companies. managerial entrenchment becomes more likely. The pattern of distribution changed little through 1992-1997.14). the ownership structure can bring about an incentive effect. fluctuated widely during the period.e. the entrenchment effect outweighs the incentive effect. Thus. However. that is. but their shares declined to 21.1 percent. and then steadily declined after 1993. Among listed nonfinancial companies. From 69. The holdings of financial institutions. i. the entrenchment effect and problems of agency may be more pronounced in chaebols than in independent firms. the Government. the percentage of holdings by individuals slipped to 60.7 percent by 1997. an entrenched manager is insulated from market pressure and can pursue personal goals without the fear of being replaced. The reduction can be . However. an increase in their ownership may bring their ownership incentives to converge with those of the minority shareholders. The controlling shareholders of chaebols hold comparatively smaller percentages of shares. Theoretically. while those owned by banks. and insurance companies increased during the period. Composition of Ownership Among listed companies. When managerial holdings are reinforced by artificial control mechanisms such as pyramiding.
1 10.1 4.5 1.8 5.5 7.9 19.5 1992 508 2.0 8.8 1995 548 2. d Constructed from data files of the Korea Listed Companies Association.2 4. etc.5 7.2 B.8 2.3 18.1 11.3 5.6 1991 505 0. of Firms The Statea Banks.5 6.3 1994 521 1. .9 26.6 12. c Data from Korea Stock Exchange.7 14.4 18.3 17.0 60.1 8.7 18.2 7.6 16.1 2.9 1.1 17.4 34.5 18. investment trust companies.4 6.2 9. a The State covers the Government and state-owned companies.6 9.5 4.3 18.3 1.3 26.3 2.5 12.9 2.0 4.9 15.2 17.1 68.2 1993 511 2.6 8.5 Note: Ownership is based on number of shares.9 37.1 18.Table 2.9 36.1 21.1 18.4 Insurance Firms Other Corporations Foreigners Individuals 39.8 69.3 5.9 1.5 1. mutual savings. b “Banks.3 1996 570 2.2 3. merchant banks. All Listed Companiesc 1992 681 1993 687 1994 698 1995 715 1996 754 1997 775 9.6 36.7 3.6 16.14 Ownership Composition of Listed Companies.7 59.9 4.4 13.6 19.7 6.2 1.6 22.5 1989 498 0.6 20.2 8.9 17.5 62.2 5.8 59. 1988-1997 (percent) Financial Institutions Securities Firms Total 28. etc.9 5.4 5.3 8.0 27.” includes commercial banks.8 5.2 8.1 3.4 5.3 39.b A.4 13.3 1.1 8.8 59.0 59.2 9.7 1990 531 0.0 5.4 14.6 2. Listed Nonfinancial Companiesd 1988 406 0.5 60.6 Year No.1 1.6 13.1 21.0 9.7 8.1 60.0 28.8 2. and finance companies.3 17.5 6.5 16.9 2.8 17.8 17.8 4.2 18.0 7.4 1997 551 1.6 16.0 5.7 7.7 9.2 2.6 9.7 9.7 4.2 5.
15).18). the Government acquired an even bigger share in several banks as part of its program to bail out these distressed institutions.16). Institutional investors. Individuals held the majority of the shares in all industries except in telecommunications. held 26. The Government’s and state-owned institutions’ (including some banks) ownership was generally small except in the power sector. the holdings of institutional investors were expected to increase significantly with the Government’s introduction of US-type investment companies in 1998 and . Before such liberalization. However. In most instances. government ownership in nonfinancial companies was remarkably smaller and more concentrated.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.17). there appears to be no significant difference in the overall shareholding patterns between the two groups (Table 2. and small companies. This is low compared with those in Japan. However. financial institutions had more shares in the manufacturing sector than in primary industries. as distinguished from individual and foreign investors. Foreigners gradually increased their equity shares in 1992 when direct purchases by them were first permitted. The ownership distribution in listed nonfinancial firms. medium. In general. with the Government continuing to hold a sizable share in the Korea Electric Power Corporation. whether partial or absolute. foreign holdings were derived from purchases through country funds and direct capital investments. indicating their heavier reliance on inter-firm financing investments. This trend can be explained by government ownership. categorized into large. electricity. When independent companies are distinguished from firms affiliated with the 30 largest chaebols. Over the years. UK. the Government was the sole owner. and US (Table 2. One minor difference is that the percentage of shareholdings by corporations is slightly higher in large-sized firms. In 1998. of some banks. 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. and service of motor vehicles (Table 2. did not vary significantly (Table 2. other corporations’ holdings shifted toward service industries. The holdings of other corporations are mainly equity investments in affiliate companies.8 percent of listed shares in 1997. Corporate holdings averaged 16 percent throughout 1988-1997. Compared with its holdings in all listed companies. indicating their increased investments particularly in the service industries with high growth rates.
3 11.1 10.5 4.9 19.6 — — 2.9 15.1 19.9 4. and Printing Pulp.4 8.4 14.1 65.3 1.2 0.0 9. Etc.3 0. Paper.7 6.2 9.3 13.7 29.2 1.0 9.5 0.8 1.0 — 39.0 — 0.1 1.3 62.7 20.1 88.1 7.0 20.9 1.7 59.9 42.2 9. and App.4 56. Rubber.9 0.2 — 0.9 23.4 62.1 0.9 1.9 66.4 Banks. Paper.3 1.2 54.2 1.9 52.7 14.9 16.7 2. Motor Vehicles Electricity.8 7.2 0.7 1.8 5.7 63.3 9.0 9.8 Individuals 83.2 — — 0.8 7. and Printing Chemicals.2 17.8 73.3 7.5 85.3 4.5 3. Gas.2 64.4 7.1 4.3 2.0 1.2 22.9 59.9 8.2 0.8 7.4 0.5 — — 0. Elecl Mach.2 0.4 5.5 — 0.1 0.7 17.6 5.5 17.3 38.3 0.6 1.7 20..4 56.8 6.9 60.7 64.8 3.1 8.1 0.0 0.8 7.2 9.5 0.4 8.5 6.7 22.0 10.5 0.0 8.3 10.7 14. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.6 18.5 0.15 Ownership Composition of Listed Nonfinancial Firms by Industry.5 — 1.1 0.8 3.0 9.2 7.1 8.4 1.2 2. 1990 and 1997 (percent) Financial Institutions The Statea — — 0.6 24.6 8.6 3.6 11.7 2.1 27.4 8. 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 .5 19.7 22.3 6.4 2.8 8.0 2.5 7.Table 2.7 2.3 57.3 0.4 1.4 — 0.5 12.8 7.9 55.3 2.b Securities Firms Insurance Firms Other Corporations Foreigners — — 0.0 Industry 1990 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.9 10.0 7.
1 2.8 57. and App.4 4.9 69.9 2.9 2.4 76.1 — 0.9 0.4 6.2 4. and Steam Supply Precision and Optical Instruments Other Manufacturing Construction Service of Motor Vehicles Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Average 1.3 15.2 5.4 — 1.2 23.5 3.5 59.9 1.5 4.2 0.9 1.3 6.0 8.4 2.6 6.9 78.6 18.2 8.6 2. mutual savings.1 6.3 60.9 5.4 2.1 54.9 2.5 1.3 57.3 6.8 2.1 18. and finance companies. a The State covers the government and state-owned companies.8 11.6 5.4 1.5 3.1 1.9 20.1997 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood. .6 6.4 9.3 65.6 — = not available.2 4.3 8. Note: Ownership is based on number of shares.0 6.4 1.7 6.0 11.6 75.7 23. and Printing Pulp.7 2.6 2.2 4.8 54.7 17.9 57.5 63. Source: Constructed from data files of the Korea Listed Companies Association.8 0.0 3.6 2.1 — 1. etc.3 0.8 2.5 — 2.4 4. investment trust companies.0 43.3 7.2 49.8 27. and Printing Chemicals.9 1. Paper. b “Banks.7 2. merchant banks.5 6.6 60. Gas.8 4.1 3.1 4.4 58. Elecl Mach.9 18.8 0. Paper.3 1.7 2.5 3.5 0.7 1.2 7.5 4.8 12.3 31. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.8 5.4 45.5 3.2 3.4 0. Rubber.7 5.1 9.4 68.8 5.1 25.78 81.4 3.4 2.4 16.7 2.9 6.4 43.0 7.1 2.0 5.0 6.4 1.2 1.7 19.9 5.2 13.5 12.6 3.9 2.2 6.1 9.6 7.2 0.0 1.0 60.6 0.5 5.” includes commercial banks.5 7.3 1.6 20.2 1.2 4.7 4. Motor Vehicles Electricity.8 6.0 4.9 6.6 14.2 5.4 20.8 2.1 3.6 0.9 7.4 58.9 7.6 1.1 1.9 20.6 59.3 2.8 3.
4 4.7 4.5 62.5 18. of Firms Independent Firms Affiliates of 30 Largest Chaebols Total 316 117 433 Source: Constructed from data files of the Korea Listed Companies Association.5 19.4 Firm Sizea No.4 17. Source: Constructed from data files of the Korea Listed Companies Association. 1997 (percent) The State 1. etc.8 4.0 6.7 1.5 8.3 Banks.5 2.2 1. Others are medium firms.4 2.4 5.8 6. investment trust companies.5 Individuals 60.4 1.9 2. b Table 2.4 2. and finance companies.5 16.1 6. The State covers the government and state-owned companies.9 5.7 Foreigners 4.7 8.c Securities Firms Insurance Firms Other Corporations Individuals 58. Securities Firms Insurance Firms 2.5 4. merchant banks.0 Other Corporations 16. 1997 (percent) The Stateb Foreigners 4.4 61.8 1.6 60.17 Ownership Composition of Listed Nonfinancial Firms by Control Type.7 0.8 2.9 4.8 4.1 2. . etc.7 Control Type No.0 1.4 5.7 6. 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.” includes commercial banks.Table 2.8 3.5 6.6 16.4 21.1 Banks. etc.1 8. mutual savings.3 6.4 61.16 Ownership Composition of Listed Nonfinancial Firms by Size.8 60. c “Banks.
rather than the individual. the majority shareholder group in all listed companies consists of the corporate.4 26. 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.1 financial institutions’ establishment of corporate pension fund accounts. investors (Table 2.18 Ownership Composition of Listed Firms in Selected Countries. This has had profound implications for corporate governance and the market for corporate control in Korea.China United Kingdom United States Source: Stock Exchange of Korea. The majority shareholder group’s shareholdings in listed nonfinancial firms steadily declined from 1990 to 1996. for example.6 Foreigners 9. and other shareholders who do not belong to either the minority shareholders or the majority shareholder group. his/her family members.7 16. Institutional Investors 42. including those of the largest shareholder.19). Among nonfinancial listed firms.8 56. Generally.5 20.1 percent and appear to be similar to the proportion of foreign holdings in the four other countries.3 54. minority shareholders. Concentration of Ownership The analysis of ownership concentration in this section focuses on shareholdings of the majority shareholder.3 6. But these may .1 8. the majority shareholder group on average held 23-30 percent of outstanding shares in the period 19881997 (Table 2. corporations held 70 percent of the controlling blocks of shares. In 1997.20).8 9. defined as those holding less than 1 percent of shares. At the moment.Chapter 2: Korea 83 Table 2. Foreign holdings of Korean shares were 9. only closed-end investment companies and traditional investment trust companies are allowed.3 47.8 10. and the companies under the control of the largest shareholder.6 Individuals 23. 1997 (percent) Country Japan Korea Taipei.5 45.6 39. while family members accounted for only 30 percent.
1 5.8 72.1 28. 1992-1997 (percent) Majority Shareholders Corporation 15. his/her family members.0 2.9 7.6 26.9 2.9 32.2 Minority Shareholders Subtotal 71. Other shareholders are those who do not belong to either the minority shareholders or the majority shareholder group.7 Note: The majority shareholder includes the largest shareholder.1 14. and the companies under the control of the largest shareholder.7 16.0 22. Source: Stock Exchange of Korea.1 4.7 18.3 2.1 32.0 4.4 5.0 66.1 21.4 7.0 25.6 2.4 3.9 Individual 2.0 Year Corporation Individual 1992 1993 1994 1995 1996 1997 41.2 26. Minority shareholders are those holding less than 1 percent of shares.3 30.7 6.2 2.0 29.8 73.8 Individual Subtotal Other Shareholders Corporation 3.6 73.0 1.2 2.3 Subtotal 5.1 15.Table 2. .6 46.5 43.19 Ownership Concentration of All Listed Firms.7 44.9 33.0 69.6 22.8 8.1 37.1 5.6 5.9 3.3 18.7 7.1 23.9 6.
0 58.6 11. It was highest in medium-sized firms before 1993 and.0 20. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Minority Shareholders 53.5 23.5 60. minority shareholders.2 15.5 12.9 Other Shareholders 18. utility companies have a relatively higher degree of ownership concentration with the majority shareholder owning nearly 45 percent of an average company (partly because these companies were owned solely by the Government before their privatization [Table 2.9 29.8 28.8 Majority Shareholders 27.4 28. In such cases.4 Source: Constructed from data files of the Korea Listed Companies Association.22).4 23. 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.7 18. in the small firms.0 22. collectively owned less than 50 percent of an average firm.8 54.6 58.1 50. rubber and plastics. In most industries. hiding shares offers no additional tax or other benefits.9 12. Besides. 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 2.21]). ownership was relatively diffused due to government regulation. Meanwhile. Majority ownership is also high in the chemicals. Ownership concentration tended to be lower in large compared to medium and small listed firms. .Chapter 2: Korea 85 Table 2. In telecommunications. The shareholders that held more than 1 percent but did not belong to the majority group held about 20 percent on average.3 62. Across industry. The practice of hidden shares seems to have been less prevalent in recent years.20 Ownership Concentration of Listed Nonfinancial Firms. and mining categories. the Government has retained a large number of shares.9 25.9 48.6 57.8 57. the majority owner held more than 20 percent of an average firm.8 12.5 13. which held less than 1 percent of a company’s outstanding shares as of 1997.9 27.8 25. thereafter.3 25.
0 30. Elecl Mach.2 34.8 51.7 21.2 26.6 53.Table 2..8 21.8 24.7 26.2 48.0 39. Rubber.8 55.6 19.0 51.5 44. and Plastics Basic Metal Fabricated Metal and Machinery Electronics.1 49.6 25.5 16.4 Industry Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.8 41.7 17.6 38.9 10.8 29.6 34.7 29.8 25.6 50.4 16.5 23.3 26.0 21.7 36.8 31.1 43. and Printing Chemicals. and App.2 19. 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 20.3 39. Paper.9 Minority Shareholders Majority Shareholders Other Shareholders 12.4 11.3 19.8 44.7 27. Motor Vehicles Electricity.5 47. Gas.7 24.21 Ownership Concentration of Listed Nonfinancial Firms by Industry.5 21.2 46. 1997 (percent) Number of Firms 3 2 43 49 12 16 90 39 31 71 34 8 9 49 40 15 1 10 29 551 36.5 41.5 52. and Printing Pulp.2 23.2 37.0 54.1 19.1 17. Paper.2 22.5 19.9 26.9 44.
5 Other Shareholders 19.9 53.6 27.5 10.4 30.9 21.9 12.Table 2.5 27.1 16.6 62.3 19.2 18.2 11.4 21.7 31.5 12.2 12.9 23.7 15.6 11.6 31.5 26.4 29. .6 55.1 58.7 57.5 28.5 49.6 15.8 52.2 21.4 47.9 60.2 Source: Korea Listed Companies Association.2 26.2 50.2 21.1 20.6 65.8 27.8 50.2 Majority Shareholders 26.9 17.4 51.0 66.0 55. 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.8 56.7 22.2 32.7 14.5 19.7 17.3 27.5 51.3 25. 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 53.8 28.7 57.5 12.1 27.9 26.3 55.6 59.0 24.4 30.3 21.9 28.8 11.3 26.2 21.0 59.2 56.2 55.8 52.6 24.9 56.0 26.8 62.9 22.9 55.1 15.4 30.8 17.7 28.2 52.5 21.1 48.5 33.5 19.7 16.9 16.22 Ownership Concentration of Listed Nonfinancial Firms by Firm Size.
Kim (1992) and Kim. H. J. from the standpoint of the controlling shareholder.88 Corporate Governance and Finance in East Asia. They analyzed firms in which controlling shareholders participate as managers. Shleifer. If SCS is below the range of 20-25 percent. if TQ is lower than 1. II Ownership Concentration and Financial Performance J. thus a firm creates value. Both studies used Tobin’s Q (TQ) for the value of a firm as an index of financial performance. Hong. For example. and Kim (1995) studied the empirical relationship between the degree of ownership concentration and financial performance in Korea. If SCS is below 10 percent. and the shareholding of a controlling shareholder (SCS) as the degree of ownership concentration. TQ was calculated by dividing the market value of a firm by the substitution price of its assets. The pattern of the relationship between SCS and TQ is similar between Korean and US firms (Mork. Inter-Firm Investments and Pyramiding in Chaebols The Commercial Code imposes limits on direct cross-shareholding. If SCS reaches 10 percent. Kim (1992) found the relation between TQ and SCS to be nonlinear. Then TQ declines until SCS reaches 45 percent and increases until it reaches 50 percent. one company from a chaebol group could obtain debt payment . Where direct cross-shareholding is not allowed. Hong. which is the company holding more than 40 percent of outstanding shares of its subsidiary. which can then pass the equity capital to a third. This type of inter-firm investment. TQ increases as the SCS increases. it means the firm creates value. often at terms unfair to one of the transacting parties. The relationship between TQ and SCS shows a similar pattern. If TQ is higher than 1. TQ has a maximum value. thus a firm destroys value. One of the merits of pyramiding. Vol. one company can still place equity investments in another. and Kim (1995) reached a similar conclusion. TQ is above 1. The Code prohibits a subsidiary company from owning shares of its parent company. 1988). TQ is below 1. This refers to the situation wherein Company A holds shares of Company B and simultaneously Company B holds shares of Company A. called “pyramiding”— commonly (though incorrectly) known as “indirect cross-shareholding”— is prevalent in Korea. H. and Vishny. affiliated companies have been able to conduct inter-firm transactions. the firm destroys value. If SCS is above 20-25 percent. The study by Kim. although turning points in the value of firms are different. In Korea. is effective control of a certain group of companies even with a smaller investment.
The extent of pyramiding can be seen in some of the previous tables. Twenty-two of the 81 respondents were independent. although they are likely to be insignificant. or about five subsidiaries each. This also partly explains why chaebols frequently opted to expand by establishing new firms rather than placing investments internally. If we define the internal shareholdings of a . dominated the majority shareholder group in chaebol-affiliated companies is consistent with the results of the ADB survey conducted for this study. Until recently. 59 parent companies collectively had investments in 759 firms. together owning an average of 37. firms linked through partial equity investments could enjoy the advantage of consolidation without an actual formal consolidation or merger of operations taking place. Among chaebol affiliated firms. Among the subsidiaries or firms receiving investments.5 percent as of 1997. Of the 81 respondents. 62 percent (16 out of 26) had a corporation as the largest shareholder. The fact that corporations. 59 were parent firms with one or more subsidiaries. for example.5 percent. or about four firms each. But the controlling power of the owners also stems from inter-company shareholdings of the subsidiaries. the average shareholding of the controlling owners and their families was 8.5 percent of shares. For the whole sample. 34 percent were foreign companies. Partial results are shown in Table 2. corporations hold about 20 percent of the outstanding shares of all listed nonfinancial firms. Thus. not individuals.14. In many instances.Chapter 2: Korea 89 guarantees from other members of the group at no cost. standalone setups. and about 11 percent were domestic financial institutions. Among the 81 listed firms in the ADB survey.9 percent of shares. Thus. the top 30 chaebols’ shareholding by subsidiaries was 34. there are instances of direct cross-shareholding in Korean firms. Only six firms (or 13 percent) indicated that their subsidiaries also owned shares in themselves. together owning an average of 38. The top five shareholders of the chaebol-affiliated firms consisted of one individual and 3. In the case of the 30 largest chaebols. In Table 2. and 319 foreign subsidiaries. or an average of 13 firms per company. For the same year.5 corporations and two individuals. 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.4 corporations. 53 percent were domestic nonfinancial firms.23. neither the investors nor the relevant government authorities were active in monitoring such unfair dealings between firms. the top five shareholders consisted of 2. together having a total of 292 domestic subsidiaries. financial institutions that are subsidiaries of a chaebol also hold shares in its member firms.
5 2.6 3.6 3.0 2.0 3.6 16.5 31.7 0.8 37.1 22.0 3.2 37.1 1.7 19.8 38. b The chaebol affiliated firms are those belonging to one of the 30 largest groups.6 34.4 18.8 31.0 13.5 4.5 4.0 1.23 Ownership Concentration in the Survey Sample of 81 Listed Firms.9 29.4 38.5 1.7 39.7 5.7 37.8 Note: The survey was conducted during the period January through May 1999 and included nonfinancial listed firms only.4 25.4 42.4 2.2 25.5 2.6 3.5 2.4 1.Table 2.1 3.0 1.5 24.8 18.4 21.0 17.5 2.9 34.9 5. . 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 38.3 12.5 18. A few companies reported less than five largest shareholders.8 8.9 21.0 21. 1999 Five Largest Shareholders No.4 11.3 26. a Number of shareholders.
pp. Thus it can be inferred that their strategy in designing the ownership structure of their business groups was to minimize the financial resources required to maintain their grip on the management of the member firms while maximizing their control. The 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. “Is the Fair Trade Policy Fair?” Korea Economic Research Institute.5 Judging from the historical record. the controlling families owned 8. New York: Praeger.4 13. Chicago. the average internal shareholding ratio of the top 30 chaebols was at least 43 percent.7 1992 46. Lee. As of 1997. 1998.Chapter 2: Korea 91 chaebol as the shareholdings of the controlling family and the member companies of the group.24 shows the average internal shareholdings in the 30 largest chaebols.” Paper presented at the Annual Conference of Financial Management Association. 1989. Table 2. Tamio.5 percent and member companies. Hattori (1989) identified three patterns based on data in the early 1980s. 1997.8 40. 6 7 Hattori. Based on these studies.2 33. the ownership patterns can be described as follows. Internal shareholdings in some chaebols also include shares owned by nonprofit organizations operated by the controlling family.24 Internal Shareholdings of the 30 Largest Chaebols. 15 October 1998.6 Later studies by Lee (1997) and Lim (1998)7 find similar patterns. it appears that the chaebol families have had a strong desire to expand their business bases. The family and member companies’ shareholdings have been declining over time. Ungki Lim. Family holdings include shares owned by the family members and by parties considered to be under the influence of the family.7 31. “The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols.2 1994 42.4 10. 1987 56. 1987-1997 Type of Shareholding Internal Shareholdings Family Member Companies Source: Korea Fair Trade Commission.” In Korean Managerial Dynamics.6 33. “Japanese Zaibatsu and Korean Chaebols. 79-95. H.4 1990 45.7 9. 34. Lee.5 percent.8 33. Chung and H.0 8. edited by K.2 12.4 1993 43. C. Many attempts have been made by researchers to identify the typical patterns of ownership structures in chaebols.5 34. Table 2. . Jae Woo.1 1997 43.2 15.
The family itself holds shares in some subsidiaries. Most of its member firms were acquired by. The Hanwha Group can be classified as such a company. For example. Chaebol Reforms Various measures have been taken to improve the transparency of chaebols with regard to accounting. consisting of eight listed and 16 privately held firms as of 1997. A nonprofit foundation under the family’s control is the largest shareholder of one of the base companies. II The first (Type A) is called “direct family ownership. Also. there is no controlling shareholder. The Hyundai Group exemplifies this. Hyundai Motors acquired Kia Motors via an international auction. or merged into. The controlling family has sizable investments in two base companies and smaller investments in many others. Vol.” Under this type of ownership pattern. is an example of this type. Sun Hong Kim. But the former chief executive officer (CEO).” A family owns a substantial portion of shares of member firms and becomes the controlling shareholder of each. holdings of the nonprofit foundation. and business activities. financial. it had 18 listed and 39 private companies. It consists of seven listed and 24 privately held firms. called the “indirect control via base company. subsidiaries have extensive investments in other subsidiaries. One of the . The fourth type (Type D) is “management control. The second (Type B). which then make investments in the subsidiaries. and his management team exercised full control over the group without much interference from major investors. The third (Type C) is “indirect control via complex shareholding. Thus. Investments between the lower level subsidiaries are rare. The Hanjin Group. Kia Motors was the base company and had such strategic shareholders as Ford Motors of the US and Mazda of Japan. the family controls the group’s member companies by its own shareholdings. completely dissolved under financial distress. As of 1997. other firms. Here the family is the controlling shareholder of one or more strategic base companies that have enough equity participation in the subsidiaries. The Kia Group was about the only management-controlled group but was out of existence by 1999.” Here the family directly controls a base company and a nonprofit foundation. investments made by the base companies. which in turn hold shares in some of the other subsidiaries. and subsidiaries’ equity participation. Its controlling family holds shares in three base companies through which they exercise control over the other member firms.” shows a simple pyramidal structure.92 Corporate Governance and Finance in East Asia. The two base companies have investments in three other base companies.
following the amendment of the law. thus hurting the shareholders of stronger firms. The limit on investments was reduced to 25 percent in 1994 and completely eliminated by 1997. Another is that the holding company should own more than 50 percent of the shares of a nonlisted subsidiary company and more than 30 percent of a listed company. The Fair Trade Act was amended in 1998 to allow pure holding companies to be established under restrictive conditions.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. Cross-guarantees are believed to constitute a form of wealth transfer from financially strong members to weak ones. One condition requires that the DER of the holding company should not exceed 100 percent. This limit was also applicable to banks and insurance companies. These conditions are aimed at restricting excessive pyramiding and expansion of chaebols. bankruptcy reorganization. However. 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. 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. They hindered early exits (liquidation. The Government is also considering whether to allow consolidated taxation for pure holding companies. the act did not have any important provisions except the standard clauses prohibiting monopolization of an industry through business combinations. 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. Also. only operating holding companies were allowed to be established. direct control of the management of chaebols was attempted through amendments of the act in 1986 and 1990. there are reports that some top chaebols are studying the feasibility of transforming their organizational structure. . The Fair Trade Act was also revised in February 1998 to prohibit cross-guarantees of debt among members of a chaebol. the Fair Trade Act). the Credit Management Regulation rules were amended to prohibit financial institutions from requiring guarantees from affiliated firms when extending new loans. At this early stage. The prohibition of holding companies was also abolished in 1999. These amendments prohibited holding companies and direct cross-shareholding. This was the reason why chaebols chose to employ pyramidal structures. A third disallows multiple layering of holding companies. Until the end of 1998. Initially. Existing guarantees had to be resolved by March 2000.
Chaebols maintain that the restructuring headquarters will exist only for a limited period. usually in the rank of a company president. until urgent restructuring is complete.3. The chairman’s office had its own chief executive officer. Some chaebols have disintegrated or shrunk in size. boards of directors.) 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. Some chaebols operated “group management boards” attended by top executives (presidents or chairpersons) of larger member firms. even though they were legally independent with their own board of directors and the outside shareholder groups were not identical. The 30 largest chaebols are now required to publish “combined” financial statements. II etc.2 Internal Management and Control Monitoring of corporate management by shareholders.94 Corporate Governance and Finance in East Asia. Despite chaebols’ decision to dismantle the chairman’s offices. 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 group chairman operated through these offices and treated the individual member firms as if they were the divisions of a single legal entity. but the larger and stronger ones still operate their newly named “restructuring headquarters” under the control of the group chairperson. Vol. It also acted as the secretariat for the unofficial “presidential meeting” of the member firm presidents. planned for capital raising and allocation on a groupwide basis. and transferred funds generated by one firm to another. 2. The staff of these organizations were employees of member firms. the Commission has strengthened its investigative activities to eradicate cross-subsidization and wealth transfer activities among group members. chaebols dismantled their “planning and coordination offices” or “chairman’s offices” under pressure from the Government. These offices were legally informal and functioned as the headquarters of chaebols. which put together the accounts of all members of a chaebol. The office established strategies for the group as a whole. In 1998. and the capital market was almost nonexistent until the recent reform . unlike the regular consolidated statements that only cover those firms that are related through direct equity participation. Since the economic crisis. there have been no significant changes. who is universally called the “group chairman. Their operating costs were borne by the member companies rather than by the controlling shareholder.
This implies that the typical agency problems in Korean corporations stem from conflicts of interest between inside (the largest) and outside (minority) shareholders. the creditors did not declare defaults. There are many reasons for this. Loan agreements and debt indentures did not include strict covenants. corporations should have a board of directors consisting of at least three members. he or she generally approves major decisions made by the management. Thus. In most listed companies. Under such circumstances. and takeover codes were not accommodative to active monitoring. Board of Directors General Characteristics of the Boards Under the Commercial Code. Banks. Directors are elected at the general shareholders meeting for a term not exceeding three years. . the representative director was also the chairperson of the board. creditors were not active in monitoring debtor firms and relied mainly on guarantees and collateral. or at least acts as the de facto CEO. especially chaebols. With few exceptions. Meanwhile. The board elects one or more representative directors from among the board members. except for banks. the concept of fiduciary duty of managers was not well established. Most companies have one representative director. the controlling shareholder is officially the representative director and the CEO. Even where the largest shareholder is not the representative director. this was complicated by the prevailing attitude that large companies. only the Government could play an effective role in monitoring corporations. in most Korean firms. Legal provisions to protect investors were limited. were too big to fail. the controlling shareholder (or a member of the controlling group) was the legally registered representative director in 354 out of 551 nonfinancial listed firms. The Government’s policy and securities law provisions to protect control rights of the incumbent management had been in place until the early 1990s. had their own governance problems. As of 1997. Even when the covenants were violated. However. Professionalism in management was not well developed and managers were content with receiving orders from controlling shareholders. but some large ones have two or more. This policy managed to hamper any monitoring initiatives from the capital market. control is not separate from ownership. as the major creditors.Chapter 2: Korea 95 efforts.
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. In order to address this concern. members of the board. . 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. Further. they were virtually under the full control of the CEOs and in practice functioned only as management councils without any decision-making power—at least until 1998. The Commercial Code was also revised in 1998 to introduce cumulative voting for the election of directors. II When the Commercial Code first introduced the corporate board system in the 1960s. However. and their positions (accept or reject) on matters voted on in board meetings. Vol. all of whom were managers. were supposed to be outside directors. the stock exchange recently amended the listing rules to require that companies disclose a detailed profile of the candidate and the person who made the nomination. there is concern that newly elected outside directors still lack independence from the management or the controlling shareholder. 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. Moreover. almost all companies succeeded in adopting cumulative voting. Most of the outside directors in those days were the controlling shareholders of chaebols or executives of affiliated companies. A few large companies had more than 50 directors. With the boards consisting only of insiders. other than the representative director(s). Recent Reform Efforts on the Board System In 1997.96 Corporate Governance and Finance in East Asia. the attendance rate of outside directors. cumulative voting is not mandatory and a company can exclude itself from its application by amending its charter. 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. In the 1999 annual shareholders meetings. companies have to disclose in their annual reports the frequency of board meetings. 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. However. Despite the qualification requirements.
1 percent and outside directors 1.4 directors.5 percent of the shares. In 78 percent of the responding firms. 88 percent had plans to hold elections in the near future. he or she held 6. The average board had 8. The Commercial Code is being amended to allow a choice between the audit committee system and the current internal auditor system.9 percent on average. In March 1999. Directors were most frequently elected because of their professional expertise (74 percent of the respondents marked this answer). the OECD principles of corporate governance were the minimum standard for the Korean Code of Best Practice. ADB Survey Results on Boards The ADB survey results confirm the above assessments and provide early indications on the effects of the reforms. they had a parent/child relationship in 20 percent of the cases. Meanwhile. Where the chairperson was not the CEO. which had extended financial support in their recent recapitalization efforts. Almost all (92 percent) of the respondents had one or more outside directors and 70 percent were elected after the Asian financial crisis. the Corporate Governance Reform Committee. the chairperson of the board was also the CEO and on average held 10. although some banks recently have established board committees. Directors were also chosen on the basis of their relationship with the controlling .1 percent of outstanding shares of a listed company. The controlling shareholder of some banks is the Government. the Korean Code recommends that large listed firms should have at least three independent directors. was established under the auspices of the Ministry of Finance and Economy and the Korea Stock Exchange. The Securities and Exchange Act will require large listed firms with W2 trillion or more in total assets to adopt the audit committee system. These results are in accordance with the new listing rules introduced in 1998.2 percent and the CEO 14. are required to have a majority of outside directors. Among the firms with no outside directors. Among others. In September of the same year. an audit committee. who would comprise at least 50 percent of the boards. having no controlling shareholders. On average. a blue-ribbon committee. This is because most banks. Where the two were separate. and a nominating committee. this committee adopted the Code of Best Practice in Corporate Governance. inside directors owned 16.Chapter 2: Korea 97 The committee structure of the board as found in the US has not yet been adopted by listed companies.
In one case. This rather long tenure must be due to their status as controlling shareholders in most firms. founders of the company acted as the chairperson (22 percent). In a very small number of firms. and shareholding (10 percent).98 Corporate Governance and Finance in East Asia. one person was sitting on nine boards and this person was the CEO of a chaebol firm. II shareholder (30 percent). Chairpersons of the board were elected on the basis of professional expertise (33 percent of the firms). The board or the management then determines compensation packages for individual directors. In 1997. the term of appointment of directors and board chairpersons is three years. However. the management determines the remuneration. In some instances. Members of controlling shareholder families or their trusted company personnel often act as directors for multiple chaebol firm boards. the board had no committees. In 91 percent of the sample firms. including stock options. In most firms. The survey results indicate that boards determine remuneration packages for chairpersons in 42 percent of the firms. Less frequently.2 years on average. Most frequently. most firms just began to elect a small number of outside directors to meet a new requirement in the listing rules and thus have no experience in the AngloAmerican type of board processes. and fixed fees plus performance-related pay. compensation for directors must be approved by the annual shareholders meeting for each fiscal year. in 23 percent. The general practice is that shareholders approve the upper limit on the total amount to be paid to all directors. Vol. The reason for this high frequency of interlocking directorship is that many listed firms belong to chaebols. Remuneration for chairpersons include only fixed fees in 76 percent of the sample firms. Some directors were nominated by significant shareholders (18 percent) or introduced (and elected) at the shareholders meeting. These were established only recently. In 13 percent. 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). election of directors was based on shareholdings (7 percent) and status as founder (7 percent). the board had a nomination and an audit committee. a total of 562 directors were sitting on two or more corporate boards. the management nominated director candidates (64 percent of the directors). in some firms. among the 81 sample firms. As discussed earlier. The current chairperson has been in office for 6. About five directors per firm have been in office for more than one term. . According to the Commercial Code. relationship with controlling shareholders (21 percent).
he or she does not enjoy much power. in which there is no controlling shareholder. compensation is by fixed salary in 74 percent of the firms. he or she was selected on the basis of professional expertise in 15 firms. and fixed salary plus performance-related pay including stock options in 13 percent. The firms in the survey consider steady growth of a company and maximization of the shareholder value as the most important responsibilities of CEO. fixed salary plus net profit-related bonus in 9 percent. CEO is entitled to a large sum in cases his/ her contract is terminated before its expiration. CEO is also the founder in 52 percent of the firms. . shareholding in three firms. However. the payment is about five times the CEO’s annual salary. CEO generally has the ultimate power to decide on corporate affairs. In a handful of sample firms. and in another 21 percent CEO bought shares in the market. CEO simply follows the orders of the chairperson. 86 percent of the firms answered positively when asked whether the largest shareholder was CEO. When CEO is not the chairperson. CEO was given shares by the family.2 years. In 4 percent of the cases. It indicates that CEO. In 20 percent. it was proposed by CEO and approved by the board. decides on important matters on his/her own in 13 out of the 44 firms. who is not the chairperson. the survey tells a slightly different story than is generally believed in Korea. In less than 20 percent of the firms. 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 decides on important matters after consulting the chairperson in the majority (55 percent) of the firms. In such cases.Chapter 2: Korea 99 Management CEO In the survey sample. CEOs have been in their positions for an average of 9. These results show that the incentive compensation scheme for professional CEOs is not well developed in Korean firms. CEOs generally maintain their positions for a long time because they are frequently the founders or largest shareholders of their firms. According to the survey. In the survey. The remuneration package was proposed by the board (and approved by the annual general meeting) in 56 percent of the firms. Ensuring that a company serves the public interest is considered a less important responsibility of CEO. In 21 percent of cases. In cases where CEO is not the largest shareholder and chairperson. In the 25 firms where CEO was not the chairperson of the board. and was appointed by the Government in five firms.
One area has been to enhance the reliability of financial statements of corporations in line with internationally accepted standards. The commission has played an active role in introducing new rules on corporate governance. and accounting standards. executives sometimes have the opportunity to buy company shares at favorable prices because the board of directors (CEO. Penalties for fraudulent financial reports were increased. 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. This action was in response to calls by international investors and. and . disclosure. it was common for all senior executives to be elected as directors at the shareholders meeting. but in practice is fixed and understood as part of a fixed salary. The bonus is supposed to be linked to company performance. Vol. (ii) establishment of accounting standards for financial institutions. About 40 percent of the listed companies had amended their charters to introduce incentive stock options by the 1999 shareholders meetings.100 Corporate Governance and Finance in East Asia. 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. 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. However. Senior managers were even often called directors although they were not official members of the board. Korean firms have rarely used shares for executive compensation. but as of March 1999 only 27 firms actually had given stock options to their executives or employees. II Senior Executives In the past. in particular. Usually CEO suggests the maximum amount of all the directors’ compensation at the shareholders meeting to get approval and then sets the base salary and bonus for individual executives. Transparency and Disclosure Accounting Standards The Financial Supervisory Commission (FSC) was established in April 1998 to take charge of supervising the financial markets and institutions. from IMF and the World Bank. in practice) allocates the unsubscribed portion of new shares issued in rights offerings to executives.
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. however. Internal and External Auditing The Commercial Code requires a corporation to have at least one internal auditor elected at the general shareholders meeting. Under the Commercial Code. In practice. but 49 percent confessed that they have not followed international standards at all. Those that never adopted international standards show their willingness to do so once the Government introduces international standards. The primary sources of reference in the revision were International Accounting Standards and US Accounting Standards. The internal auditors are supposed to play the role of the audit committee found in the board of directors in US corporations without being members of the board. the internal auditor is considered to be a subordinate of the . 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. Thus. 41 percent of the companies believed that they have followed some international accounting standards. they also have the power and duty to monitor the activities of executive directors. Korean listed companies with subsidiaries are required to compile consolidated balance sheets. The new accounting standards for financial institutions adopt the mark-to-market basis to account for securities. Only 10 percent of the respondents have followed all international accounting standards.Chapter 2: Korea 101 (iii) establishment of accounting standards for “combined” financial statements of chaebols. they cannot be expected to discharge this responsibility because the representative director selects the internal auditor and can force him or her to resign. Consolidated reporting was introduced before the outbreak of the crisis. 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. In the ADB survey. The revised accounting standards apply to the firms subject to external auditing for the fiscal year starting on or after January 1999. Most of the companies following all or some of the international standards in the past adopted such standards before the crisis started. 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.
About 100 listed firms will be subject to this requirement. then the Securities and Futures Commission can appoint a new one. does not have the power to hire and fire the managers. Previously. 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.102 Corporate Governance and Finance in East Asia. In the ADB survey. Big Korean accounting firms are affiliated with US accounting firms. and creditors selects it. In the past. Vol. But this problem can be mitigated if auditors function under the umbrella of the board. The current external auditors have been associated with the surveyed companies for an average of 4. 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. and lack of strong professional ethics in the accounting profession. 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. however. . underdeveloped market discipline for accounting firms. Accepting these arguments. The Commercial Code will be revised to allow corporations to choose from the two options: the internal auditor or the board audit committee system.6 years. outside directors. In order to increase independence. almost all firms affirmed that the external auditor is independent from the company. as a monitor of management in the Korean (and also the Japanese) system. The 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. the board of directors had the power to appoint an external auditing firm. but since 1998 a committee consisting of internal auditors. External auditors are selected for a term of three years. If the status of internal auditors is elevated to that of independent board members. II controlling shareholder/CEO. there were many cases where external auditors failed to detect omissions and false numbers in financial statements of listed firms. The problem of misconduct on the part of the external auditor was caused partly by weak penalties on wrongdoing. this problem will largely disappear. Listed and registered corporations must publish financial statements audited by external accounting firms. The general organizational/social culture in Korea abhors conflict and may also have hindered effective functioning of internal auditors. This is because the auditor. the relevant laws and regulations were changed after the Asian crisis to require at least one of the internal auditors to be full time and to recommend that listed firms have outside (independent) auditors. If the company changes its external auditor for reasons that are not listed in the relevant regulation.
respectively. A total of 326 shareholders per firm. Thus.” The survey shows that the Korea Securities Depository holds 69. The Depository represented 20 percent of the shares attending the meetings. About 100 shareholders per firm voted by proxy at the last annual general meetings (of the 40 firms answering the relevant questions). 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. attended the last annual general meeting. A “special resolution” requires two thirds of the votes attending and one third of total votes outstanding. and dismissal of directors and internal auditors require a “special resolution. No companies have so far introduced voting by mail. Preferred shares can be nonvoting and issued up to one quarter of the total number of shares. The securities companies and banks are the second and third. About one fifth of the listed firms issued nonvoting preferred shares.77 percent of the shares.21 percent of total shares issued. Internet.53 percent of the total shareholdings. This shows that a relatively larger number of shareholders send in their proxies.79 percent of the shareholders.” Companies can increase the number . corporations cannot issue common shares without voting rights. the Depository is instrumental in getting resolutions passed. The management is the most important proxy.93 percent of the shareholders but 26. the Depository is subject to “shadow voting.3. The above results indicate that. Approval of mergers and major divestitures. However. for some firms. in general. voting by the Depository can influence the outcome of votes because an “ordinary resolution” of the general shareholders meeting requires a majority of the votes attending and one quarter of total votes outstanding. However.” meaning that it should divide its votes in accordance with the accept/reject ratio of votes cast by other shareholders attending the shareholders meeting. or 10. charter amendments. Citizens’ coalitions sometimes solicit proxies in order to file lawsuits against a management. or telephone.Chapter 2: Korea 103 2. representing 62. One common share should have one vote. Under the Commercial Code. amendments of the articles of incorporation require a “special resolution. the only purpose of allowing the Depository to vote was to help listed companies to meet the quorum requirement for the general shareholders meeting. These voters represented only 5. small shareholders do not attend the annual meeting and that.3 Shareholder Rights Voting Rights and Practices Under the Commercial Code.
Shareholders have preemptive rights. For recommendations for dismissal of directors and internal auditors.0 percent. Various measures have since been taken to improve investor protection. Those that are most likely to be rejected relate to election of directors. dividend proposals. the Tiger Fund. Proposals put forward by management are rarely rejected at the general meetings. 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. an activist citizens’ coalition has brought shareholder derivative suits against several large listed firms. mergers and acquisition plans. Due to the changes in rules for investor protection. the annual general meeting passed a resolution that was not proposed by the management nor the board of directors but rather by shareholders. This coalition also attempted to cooperate with domestic and foreign institutional investors to find their way into general shareholders meetings. was able to force a change in the charter of SK Telecom. from 3 to 1. Changes in the authorized capital require an amendment of the articles of incorporation. demand changes in business policy. the Securities and Exchange Act was revised to lower the representation requirement for shareholder derivative suits from 1 to 0. This citizens’ coalition actively contacted the management of selected companies and negotiated measures to protect shareholders. In February 1998 and again in March. Shareholder Protection Before the economic crisis. II of votes required for a resolution to amend the articles. an institutional investor based in the US.01 percent. The company also agreed to the right of the fund . The charges included self-dealing by a controlling shareholder and unfair subsidization of affiliated companies by a chaebol firm. and major investment projects (only five firms answered this question). In four out of 62 respondents.104 Corporate Governance and Finance in East Asia.5 percent. or block charter amendments considered harmful to minority shareholders. the board of directors decides on issues of shares within the limit of the authorized capital. and for access to unpublished accounting books and records. Vol. the requirement was lowered from 1 to 0. Only two out of 62 respondents to this question have had cases in which proposals were rejected. It also attended the shareholders meeting of several companies to present the views of outside shareholders. As an example. However. but these can be waived by an amendment of the articles of incorporation. laws and regulations were generally very loose in protecting the rights of minority shareholders.
and transactions with major shareholders.3. Thus. controlling shareholders have become more susceptible to liability claims by other (minority) shareholders. the Government had for some time pushed for the enactment of class action suits on false statements and omissions in disclosure materials. managers were considered to be subject to the duty of care. The laws and regulations of the country protect shareholders from interested transactions. mergers and acquisitions. In fact. 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. Banks have played some limited role in monitoring the investment activities of chaebols. there was the usual conflict of interest problem and the trustee did not have the incentive to strictly enforce the covenants. loans to directors.Chapter 2: Korea 105 to recommend two directors to the corporate board. Before the amendment. and not strictly enforced. 2. In 1974. . 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. This has strengthened the accountability of controlling shareholders as de facto CEOs. These have to be disclosed under the Securities and Exchange Act or approved by shareholders under the Commercial Code and other laws. underwriting securities firms acted also as trustees. simple. bond indentures are only a few pages long compared to a few dozen pages found in advanced bond markets. For further protection of investors. affiliated lending or guarantees. After the economic crisis. However. The Code has also been amended to state more clearly the fiduciary duty (of care and loyalty) of the management. but it was not entirely clear whether they had the duty of loyalty as well. Banks themselves were poorly governed and bank managements had little incentive to monitor borrowers. creditors did not interfere with the management of a debtor. it now appears that it has backed away from its earlier efforts to introduce legislation on class action suits.4 Control by Creditors Role of Creditors in Corporate Monitoring Traditionally. This was one of the most significant developments with respect to shareholder activism in the Korean capital market. As for bond issues. The covenants in loan agreements and bond indentures were very loose.
Vol. Under the system. ADB Survey Results on Borrowing and Lending Practices The ADB survey shows that a typical nonfinancial company is associated with various types of creditors. as discussed earlier. there have been concerns that the Government might use the system to intervene in the management of the business groups. 11 banks. The 10 largest business groups are required to select no more than three core companies in consultation with their respective main banks. this proposal has only a slim chance of being accepted by the Government or legislature. Besides the setting up of an “External Auditors Committee” by firms. The firms subject to the system are required to get the approval of the main bank prior to purchasing real estate. In 1994 the approval requirement was abolished. and purchases of real estate. 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.106 Corporate Governance and Finance in East Asia. 10 nonbank . 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. II acquisitions. a main bank is charged with collecting and analyzing financial information of the firm and delivering its opinion on various applications and matters requiring consultation among lenders to the firm. The main bank should also monitor and restrict extension of loans to the controlling shareholder and other firms in the group. including. creditors now have a bigger say in court proceedings for receivership and composition. On the other hand. The objective of the system is to improve the financial condition of the largest business groups and promote the soundness of bank management. However. In turn. 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. However. on average. recently banks have been increasingly interested and successful in electing former bank officers as outside directors of firms that underwent workout processes. the main banks should review the feasibility and financing plans of projects undertaken by the core companies and monitor their financial conditions and prospects. In 1996.
About 60 percent of the firms have experienced renegotiation of loan repayment with creditors during the last five years. and purchase or supply of raw materials. banks are most likely to require collateral. One tenth of the firms received assistance from the Government in loan applications. NBFIs infrequently ask for collateral. Most of the financial institutions are not affiliates of the borrowing company. payments were usually rescheduled through negotiation without any penalty. The typical company has also maintained its relationship with five of the 10 NBFIs for more than five years. About half of the respondents received assistance from other sources in the form of loan guarantees and/or provision of collateral. and 17 nonfinancial corporations. penalty was involved in rescheduling. For more than half of such firms. Among the creditors. collateral is more likely to be required of loans for working capital than for fixed investments. 16 percent . whereas seven of the 17 nonfinancial corporations are. Most of the 43 firms with renegotiation experience were able to borrow from the same creditors afterwards. controlling shareholders. With respect to the types of loans.Chapter 2: Korea 107 financial institutions (NBFIs). Relationships with affiliated companies providing guarantees or collateral include ownership of each other’s shares. or through their shareholdings. Breakdown of loan guarantors is as follows: about 40 percent of loans are without any guarantees. mutual guarantee agreements. More than half of the firms think that creditors have no influence on their management and decision making. When loans could not be repaid on time. subsidiaries. holding companies. holding shares of another company by both the borrower and the guarantor. Most firms feel that requirements for collateral have been tightened since the crisis started. A few creditors exercise influence through covenants relating to major decisions by the company. while a third think that creditors have weak influence. The borrower’s relationship with most banks has lasted for more than five years. most frequently in the form of loan guarantees and less frequently by arrangement of guarantees by a third party. in order of importance: affiliated companies. 35 percent are guaranteed by the company itself (by collateral and purchase of guarantee insurance). The assistance came from. collateral was taken away. Only a few feel that creditors have very strong influence. renegotiation took place after the crisis. For a small number of firms. or creditors filed for receivership. Creditors usually exercise their influence through covenants relating to the use of loans. and other financial institutions.
4 percent by subsidiaries. and 1 percent by the Government. including commercial and merchant banks. the Korean Government maintained a policy of protecting the incumbent management of listed companies. In cases where the creditors are unable to reach an agreement on a workout plan. the lead creditor banks formally signed Capital Structure Improvement Plans with chaebols. the delegation has the right to approve wide-ranging financial activities of the firm. 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. and in continued monitoring of debtors.5 The Market for Corporate Control Government Policy Toward Hostile Takeovers Until 1994. This agreement will provide guiding principles in coordinating diverse interests among creditor institutions and promoting cooperation. Vol. 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 . will get involved in the restructuring and workout processes. Separate from but emulating the CRA. the Corporate Restructuring Coordination Committee (CRCC) will provide arbitration. The new ways through which creditors. the creditor banks will send a delegation composed of bank officers to the workout firm to oversee its management. a Lead Creditor Council Agreement was signed for restructuring the top five chaebols. banks and other institutional lenders are playing more important roles than ever before. This committee was set up in accordance with the provisions of the CRA. Third. 2 percent by holding companies. 2.108 Corporate Governance and Finance in East Asia. II by other affiliated companies. The leading creditor banks will continuously monitor the progress in implementing the signed Plans. Second.3. have been the driving forces for restructuring activities of the largest 64 chaebols. are summarized below. First. Under a contract signed between the creditors and the debtor. In this connection. Behind these new strengthened roles of creditors is the newly set-up FSC. 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. especially banks. major creditors.
Privately placed CBs cannot be converted into shares in one year. In one case. a total of 13 hostile takeover attempts occurred. Limits on acquisitions of shares of a Korean firm by a single investor were gradually increased over a six-year period beginning in 1992. 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). The shareholders already owning more than 10 percent at the time the company went public were exceptions to the rule. Poison pills cannot be used mainly because companies cannot distribute stock options as dividends to shareholders. Publicly issued CBs require three months before their owners can convert them to shares. Unlike Germany. but were completely eliminated in 1998. For takeover defense. Takeover Activity As soon as the Act was amended. corporations cannot limit the voting rights of large shareholders to a given maximum. In the early 1990s the Government shifted its policy toward freer activities in the market for corporate control. . As far as institutional arrangements are concerned. more than half of these attempts failed. Korea does not have the mandatory takeover rules applying to those who amass more than 30 percent of the shares outstanding (until 1998.Chapter 2: Korea 109 unless he or she obtains prior approval of the Securities and Exchange Commission. 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. Between 1994 and 1997. Stock purchases by tender offer were also exempted. 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. Companies have also utilized share repurchases. hostile takeovers by tender offers began to appear in the capital market. The reasons for failure are diverse. and announcing competitive tender offers by the controlling shareholder. The incumbent controlling shareholders used various tactics such as issuing privately placed CBs. A company cannot issue new shares to a third party without first amending the corporate charter. turning to white knights. it can be safely stated that Korea now has one of the most accommodating capital markets with respect to hostile takeovers in the region. listed firms rely mainly on shareholdings by the largest shareholder. However. 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. Unlike the UK.
Many of the takeover targets in the past did not have a controlling shareholder (group). the Government became the largest shareholder of several commercial banks through equity participation purporting to recapitalize them out of financial distress. In 1999. 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 which the Government still holds the largest ownership. As of the end of 1997. 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. Some had two or more large shareholders who had joint control of the firm but could not cooperate. was newly listed. In their charters. the limit will be eliminated when it is fully privatized in two years. Hostile takeovers in Korea will be rare in the future. 172 firms (or 22 percent of listed firms) belong to the 30 largest chaebols.3. For the others. Vol. 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.110 Corporate Governance and Finance in East Asia. For the steel company. which are allowed by the Securities and Exchange Act to set the limit on the ownership of shares by one single shareholder.6 Control by the Government State-Owned Enterprises Government ownership of listed companies is very limited. are designated as public companies. 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. Korea Telecom. 2. It is harder now to find such firms. The Government-owned listed companies. an electric power company. Another reason is that many listed firms belong to chaebols. As of February 1999.7 percent on average as of the end of 1997 for nonfinancial listed firms). except for the banks. 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. Currently the limit is 3 percent. and a bank had government ownership. Charter amendments have also been employed by some firms to limit the maximum number of directors. a steel company. some firms have included a supermajority provision for the dismissal of directors and provided for a staggered board. . In 1998.
Even where employees hold . Beginning in 1999. Control Over Private Companies One of the pronounced purposes of government intervention in the corporate sector has been to prevent concentration of economic power in the hands of a few large chaebols (see 2. the main bank system. 2.3. the Government. is being applied to the 51 largest business groups to which the banks extended more than W250 billion in loans and payment guarantees. more state-owned corporations became subject to this new board structure. Labor is not represented in corporate boards. which limits the total amount of bonds issued by the five largest chaebols.Chapter 2: Korea 111 The Government used to appoint a few public officials to the boards of state-owned corporations. which was introduced in 1996. administering through a self-regulatory committee of the securities industry. There were also limits on the amount raised and the number of issues per year.3. The objective of the system was to improve the financial condition of the chaebols and to promote the soundness of bank management. But this rule. The nonexecutive directors are now recommended by a committee. controlled the total amount of corporate bonds issued per month and allocated amounts to individual corporations.7 Employee Participation in Corporate Governance Employee participation in corporate governance is very limited. especially those belonging to chaebols.1). Meanwhile. The Government’s right to send public officials to the boards was eliminated. as applied to four large corporations. The Government has frequently imposed restrictions on the use of capital markets by large companies. For example. was amended in 1997 to introduce a board structure consisting of a majority of nonexecutive directors. Further. went into effect in 1998 to prevent them from absorbing too much of the funds available in the market. In addition. There is no active debate or discussion going on about this potentially difficult issue. This was aimed at limiting the supply of bonds thereby stabilizing interest rates. only qualified firms could issue new shares. and approved by the Chairperson of the Planning and Budget Commission. 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. nominated by the minister in charge of the company in question. It was abolished before the economic crisis but another regulation.
of which 2 percent were senior managers. Employee stock ownership plans became popular in 1974 when the Government allowed tax and financial benefits for stock purchases by employees. This practice may be due to the fact that employees are typically submissive to their employers and that their total shareholdings are minimal. About half of these firms considered the influence of the union on the management of the company to be weak. Employees of companies have had the opportunity to buy shares of their employing businesses at favorable prices. operation.1 in 1997. 2. In 1987. carried out at the enterprise level. The union had no influence on the management in 17 percent of the firms. In 70 percent of the firms with organized unions. This law is not intended for wage negotiations but for employers to seek cooperation and productivity increases from workers. II shares of their companies through employee stock ownership plans. Collective bargaining is. Under another law enacted in 1972 to induce private companies to go public. In these firms.5 in 1990. Trade unions are organized on an enterprise basis. but 27 percent of them felt that it was strong. At the national level. The percentage of shares held by the employee stock ownership plans in listed companies was 1. Under the Labor Management Council Law.9 in 1980. The respondents of the ADB survey had 2. Under the Capital Market Development Act of 1968.112 Corporate Governance and Finance in East Asia. 32 percent technicians and professional staff. there are two federations of labor unions. Vol. the management usually consults the union on major issues relating to the management. employers are required to meet with representatives of labor unions at least once every three months. these firms have to offer 20 percent of the shares being issued to their employees at the public offer prices. employees of listed firms issuing shares through rights offerings are entitled to 10 percent of the rights. . In actuality. Local unions in the same industry have established industrial labor federations. The relevant regulation was amended recently in order to facilitate voting by individual employees. and development of the company. the council meetings have been superficial. Two thirds of the respondents had an organized union. 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. and 66 percent manual workers. union members account for 54 percent of the employees.654 employees per firm on average. The typical collective bargaining agreement has a one-year duration. which were generally much lower than estimated values. they delegate their voting rights to plans’ representatives. in principle. and 2.
Chapter 2: Korea 113
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
II Interest Rate Deregulation Plan. Since 1985. Some policy loans were also abolished. entry barriers to banks and NBFIs were lowered in an attempt to promote competition.5 percent in November 1981. which resulted in the establishment of a number of new banks.2 Patterns of Corporate Financing Corporate Financing Practices In this section. budget.2. Internal funds include retained earnings. The capital market.1). as a first step toward liberalization of capital account transactions. revision of the credit control system. In addition. Moreover. short-term finance companies. depreciation. .118 Corporate Governance and Finance in East Asia. flow of funds analysis was used to examine patterns of financing of the aggregate corporate sector. the Korean Government announced its Financial Liberalization and Market Opening Plan. Korean firms have been allowed to issue CBs in international financial markets. the required reserve ratio was substantially lowered from an average of 23 percent in 1979 to 3. In June 1993. development of the money market. listed companies. the business scope of financial institutions was greatly widened from the early 1980s. The plan was launched partially to accommodate US demands for comprehensive structural deregulation and market opening of the financial sector. Meanwhile. The Government began to considerably deregulate foreign exchange in 1987 due to the shift of the current account into surplus in 1986 (see 2. finance companies. and organization of commercial banks. etc. and the 30 largest chaebols. the Government announced a plan in 1981 that substantially improved foreign investors’ access to the domestic capital market. The Government handed over its controlling stakes in four commercial banks to private hands in 1981-1983. the following measures can be constructed: Self-financing ratio (SFR) is the ratio of change in internal funds to change in total assets. The Government adopted a cautious approach. mutual savings. With the privatization of nationwide commercial banks. Vol. was liberalized drastically in 1998 after the financial crisis.4. On the basis of flows of funds. 2. the Government simplified various directives and instructions regulating personnel management. and liberalization of foreign and capital transactions. It included such important issues as interest rate deregulation. especially the domestic bond market. implementing the first stage in November 1991. opting to bring in the plan step-by-step to avoid market dislocation from a sudden shift in the system. Also.
Incremental debt financing ratio (IDFR) is the ratio of change in total borrowings to change in total assets. comprising internally generated capital (retained earnings. depreciation.26 shows the four measures of corporate financing calculated from Table 2. the proportion of borrowings from NBFIs fell to its lowest value at 4 percent. This high proportion deprived Korean businesses of flexibility during recession periods due to high financial costs. Additional equity capital used to finance growth reduces the financial cost and the financial risk of investment. capital surplus. Securities finance became a more important source from 1988 onwards. the proportion of foreign borrowings in total finance rose steadily. particularly in the short term. New equity financing ratio (NEFR) is the ratio of change in equity (stocks issued + equity other than stocks) to change in total assets.Chapter 2: Korea 119 and net capital transfers from the Government. This means that internal funds after dividend payment were insufficient to finance growth in total assets. Table 2. and allowances) and new equity capital. The share of external financing. was 71 percent during the period. and government transfers. Incremental equity financing ratio (IEFR) is the ratio of change in stockholders’ equity to change in total assets or 1-IDFR. except in 1991. the corporate sector’s most important source of external finance was bank borrowings. It measures the degree of financing growth in total assets by additional debts. 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. It measures the degree of financing growth in total assets by additional equity. depreciation.4 percent in the precrisis period 1988-1997. except for the stock market boom of 19871988. In 1988 when the stock market boomed. but it remained less than 10 percent of total financing. but do not include capital surplus (asset revaluation allowance and the excess of current value over issue value of stock). financing by corporate bonds and CPs was more significant than by new equity. particularly in the 1990s in response to the liberalization of the capital market.25 shows the flow of funds of the nonfinancial corporate sector in Korea during 1988-1997. including all sources other than retained earnings. on average. Equity capital represents the shareholders’ commitment to the business. The corporate sector used . Financing Patterns of the Aggregate Corporate Sector Table 2. Before 1988. The SFR averaged 28. In securities finance. Meanwhile. and 1997. 1994.25.
8 — 26.4 8.9 0. a Includes retained earnings.7 10.1 72.4 27.1 2. and Flow of Funds.6 Sources of Funds Internal Financinga External Financing Bank Borrowings Banks Nonbanks Merchant Banks Insurance and Others Securities Natl.1 8.1) 6.6 10.Table 2.5 2.2 (0.1 (1.3 3.8 17.8 -2.3 5.2 34.0 9.4 21.0 17.5 16.1 3.1 10.4 3.2 6.7 2.3 — 30.6 5.9 2.6 8.0 (0.9 10.0 3.2 1.8 1.4 2.6 4.0 22.6 9.4) 13.2 13.2 14.6 14.3 6.1 — 27.6 0.8 4. which is the excess of current value over issue value of stock.2 15.6 9. depreciation.7 8.0) 12.4 0. and net capital transfers from the Government.0 0.0 16.9 6.7 7. 1988-1997 (percent) 1988 43. Bank of Korea. .5 29.2 — 28.0 2.0 11.3 1.4 2.4 11.2 26.8 27.5 2.7 10.6 4.5 9.4 1.5 0.0 3.4 0.8 1.3 3.6 0.0 0.1 17.7 2.1 3.1 1.7 1.1 12.1 0.5 16.3 6.0 5.3 1.0 — — — — 8.6) 5.0 9.9 34.7 (0.9 38.3) 11.1 27.6 2.4 (2.8 (0.4 15.0 1.7 73. 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.2 — — — — 9.8 8.0 1997 26.7 1989 1990 1991 1992 1993 1994 1995 1996 22.3 16.7 12.8 1.7 14.25 Flow of Funds of the Nonfinancial Corporate Sector.1 23.6 (0.7) 11.7 2.6 11.8 0.1) 4.6 3. Bank of Korea. b Includes capital surplus.2 6.2 2.6 77.7 71.0 10.1 3.8 1.4 27.0 70.1) 4.7 32.9 72.4 — 28.6 0.5 0.2 10.9 28.1 — — — — 12.1 (0.6 9.4 2.9 9.7 14.5 2.8 1. 1994.7 4.6 11.1 36.1 1.6 3.4 1.0 3.8 56.7 4.9 10.7 10.4 27.1 1.3 72.6 4.3 2.3 27.2 5.7 15.4 71.4 9.6 0.7 1.4 (0.2 13.7 11.7 — — — — 9.3 6.4 2.3 1.9 73.8 15.3) 15.2 0.7 13.3 10.4 10.3 30.5 13.3 25.7 6.3 — — — — 8.1 2.8 30.1 0. Source: Understanding Flow of Fund Accounts.6 1.5 0.5 2.7 8.6 25.
4 percent.3 59.5 and 76. higher than the aggregate 28.6 percent.0 42.5 percent in 1997.5 12.6 percent and 1.27).4 37.6 26. was financed by additional debts.6 percent. On average.1 percent in 1988 during the stock market boom. Lower income diminished the industry’s equity position toward crisis year 1997.7 30. IDFR reached 73. Across industry.6 Excludes capital surplus.1 17. in the manufacturing sector. an average of 59.5 31.0 57. 1994. and IEFRs were declining. NEFRs.6 percent over the 10-year period. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average a SFRa 43. Bank of Korea.3 percent in 1997.1 12.3 12. but also continuously fell.4 12.4 IEFR 63. Its IEFR and NEFR dropped to 23.0 11.3 60.0 5. respectively.9 28. the corporate sector relied heavily on external financing for its expansion.5 percent.2 percent of incremental asset growth was financed by equity.6 62.9 percent by 1997 when net profit margins were negative.1 26. average SFR was 37.7 9. dropping to 26.9 46.26 Financing Patterns of the Nonfinancial Corporate Sector.8 10.8 28.2 IDFR 36.5 68.3 11.0 27.2 percent of the growth in total assets. There were significant time trends. 45.3 27.3 59. additional equity to finance 12.Chapter 2: Korea 121 Table 2.7 40.8 62.2 37. While SFRs.4 percent (Table 2.9 22. but plunged to 5. Source: Calculations from Understanding Flow of Fund Accounts. The balance. and Flow of Funds.1 53. and the total debt ratio was much higher in 1996 and 1997 at 62.4 27.3 73. respectively. higher than the aggregate 40. .4 NEFRa 20.1 39.9 60.7 40. Bank of Korea. SFR peaked at 44 percent. declining to 26. It dropped to 28 percent the following year. Manufacturing financed 54.8 percent of its total asset growth through debts.7 40.7 percent in 1997.7 26. Incremental financing from equity was 40. IEFR ranged from 32 percent to 64 percent of asset growth during the boom years. In periods of high economic growth such as in 1988. indicating a high financial risk position. NEFR registered 20.4 percent.7 28.
7 37. then increased to 20.8 IEFR 65. Categorized according to company size.122 Corporate Governance and Finance in East Asia.9 percent.6 37.4 45. the utilities (electricity. Financing patterns of the wholesale.5 76. the two sectors also had low equity financing ratios and high debt financing ratios.1 29.8 4.6 54.7 47. from 17. Since 1992. and steam) and the transportation.6 53.7 percent in 1996. II The construction industry showed the most cyclical pattern in annual asset growth.2 21. Equity financed an average 25.0 42.3 28.6 53.1 percent of total asset growth for the period. this dropped further to 15. one year ahead of the other industries. These sectors had relatively low equity financing ratios and high total debt ratios in financing asset growth between 1988 and 1997.4 3. and communication sector had relatively high incremental equity ratios.3 52.8 percent in crisis year 1997. the proportion of short-term borrowings in total financing has been high. explaining partly the collapses of several construction companies in 1995.6 62. On the other hand.9 IDFR 34. and fell to about 10 percent in 1997.0 57.5 23. storage.2 5.4 54. which decreased to 8.6 4. Vol. gas. It had the highest average SFR in 1988 at 31. and low total debt and short-term borrowing ratios.9 6.27 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. Total debt financed an average 74.6 3.0 42. Table 2.5 7.8 percent in 1990. large firms showed more cyclical patterns in these financing ratios than small. and hotels sector and realty/renting/business activities sector were similar.2 3. their average SFR was higher.4 37.and medium-sized firms.7 37.2 percent in 1993.6 37.0 30.5 NEFRa 9.4 47.8 50.2 . In 1997.7 47.4 46. retail.4 63. with the total debt ratio much higher in 1995-1997 at 82 to 84 percent.6 45.5 1.0 3.2 62. Since large firms were more profitable.9 percent of asset growth.6 36.
5 1.0 1990 50.9 9.6 9.7 78.1 69.2 1995 16.0 17.3 4.2 25.3 8.9 20.2 70.3 4.0 65.9 52.9 16.0 40.3 10.5 29.2 18.7 6.8 25.0 74.1 19.6 73.4 IEFR 46.4 28.5 1993 22.9 1993 63.7 Wholesale/Retail Trade.8 2.7 15.3 7.8 76.3 19.6 8.8 70.4 26.0 34.2 Average 53.6 7.1 66.4 62.6 8.2 29.5 87. Household Goods.0 1992 24.9 1.5 23. Hotels 1988 33.2 46.2 23.0 0.5 62.0 10.3 84.9 47.5 1996 42.8 81.0 82.6 37.9 80.5 70.8 54.1 84.1 4.Table 2.0 .8 74.9 Construction 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 31.6 9.2 74.8 9.6 71.9 2.6 4.7 1997 8.7 78.2 4.4 2.4) 2.0 31.2 5.9 1. Storage.7 53.7 15.9 1.8 1991 51.4 1995 53.0 4.7 80.2 10.0 1.3 1996 16.3 47.2 8.9 1989 63.27 (Cont’d) Year SFRa NEFRa IDFR 53.0 3. and Communication 1988 64.7 42.7 1989 26.6 14.7 41.8 29.1 Trasport.9 15.6 1997 29.1 25.3 57.3 (9.0 1990 12.0 60.8 4.9 30.7 7.9 29.0 68.8 1994 15.9 1992 56.6 2.9 33.5 20.1 70.3 21.5 76.6 37.5 12.2 3.2 20.7 1994 53.9 Average 19.1 1991 14.5 21.1 59.
6 1997 23.4 0 0 0 0 1.1 1989 34.8 1993 11.0 0. a Excludes capital surplus. and Business 1988 51.2 63. IEFR = incremental equity financing ratio.9 57.9 28.5 22.8 17.and mediumscale firms.4 (107.4 5.5 8.8 135.4 1996 45.4 IEFR 69.6 1995 17. SFR = self-financing ratio.0 43.1 54.4) 3.1 35.6 52.3 Electricity.5 77.0 67.1 0.0 79. Vol.3 85.0 1.1 34. II Table 2.0 46. The large firms had a higher proportion of external financing in 1996-1997.8) (35.8) 7.0 1992 51.0 53.4 1994 72.8 36.4 47.and short-term borrowings of these firms shot up in that period.7 14. and Steam Supply 1988 118.7 1996 18.0 0.7 70.3 3. Financial Statement Analysis Yearbooks.0 (0.3 207.3 7. Renting.2 1992 18. Source: Calculated using data from Bank of Korea.3 92.3 62.4 1.6 1989 118.6 1.3 31.1 1991 56.0 33. . Long.9 29.9 45. Gas.0 56.7 18.0 21. Their average IEFR was also higher and IDFR smaller.6 1991 18.7 37.6 IDFR = incremental debt financing ratio.8 Average 22.3 81.6 Real Estate. when large firms had much lower equity financing ratios and higher debt financing ratios than small. however. Higher growth in total assets and sales and easier access to debts by large firms could be reasons for this.9 IDFR 31. NEFR = new equity financing ratio.4 7.7 69.1 42.27 (Cont’d) Year SFRa NEFRa 6.4 0.124 Corporate Governance and Finance in East Asia.8 1990 19.9 65.3 29.1 1993 55.6 1990 82.7 1994 8.1 71. The trend was reversed in 1996-1997.0 1997 24.1 70.6 7.4 1995 62.9 Average 75.9 64.
Group-member firms borrowed less.1 percent of their equity capital.9 percent. the IDFR of listed companies increased to 93.8 percent. the top 6-10 chaebols.30). In 1997. the average SFR was 28. and using cross-payment guarantees among affiliated companies. . Many firms affiliated with the top 30 chaebols saw loan guarantees turn into their own debts because of defaults in debt payments.2 percent. but higher than that of listed companies. They had easier access to bank loans and the markets for corporate bonds and CPs than nonlisted companies. compared with the entire corporate sector’s 35 percent and 65. the top 11-30 chaebols had the highest guarantees commitments at 207. They were able to borrow easily from banks by issuing corporate bonds and CP.3 and 89. The average IEFR and IDFR were 10.8 percent of their total finance in 1997. All of the top 30 chaebols relied heavily on short-term borrowings.7 percent for all listed companies. and higher than that of listed companies (Table 2. Cross-payment guarantees have been declining since 1993 and reached 91.29).3 percent of their equity capital in 1997 (Table 2.7 percent. Their shortterm borrowings accounted for 86. about the same as that of the corporate sector as a whole. External financing reached 94. The average IEFR of the top 30 chaebols of 29. the NEFR of the top 30 chaebols plunged while the debt ratio increased substantially.5 percent and their total external financing. The largest borrowers were the top 11-30 chaebols. and the top five chaebols. Financing Patterns of Chaebols For chaebols.7 percent.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 2.6 percent.28). compared with 89. at an average 70.9 percent. the lowest ratio of 58. In 1997.4 percent. The debt financing ratio of listed companies was high since they relied more on external financing. 153. In 1996-1997. 91. for listed companies.5 percent is lower than that of the corporate sector in general. The chaebols’ drive to expand their empires resulted in heavy borrowings.6 percent of total asset growth. Another key feature of corporate finance in Korea is the widespread use of loan guarantees among the top 30 chaebols. and were large borrowers. The proportion of their short-term financing averaged 72. respectively.
1 8.5 Year 1994 1995 1996 1997 Average a Excludes capital surplus.8 76. .4 12.5 8.6 11.2 10.Table 2.9 NEFRa IEFR 14. 1994-1997 (percent) SFRa 41.6 61. Table 2.3 5.1 1.4 88.8 89. Korea Federation of Industries.4 38.2 NEFRa 1.5 2.9 7.7 13.5 2.5 8.9 6. Largest Business Groups in Korea.6 1.29 Financing Patterns of the Top 30 Chaebols.2 23.6 0.7 12.4 29. Source: Calculated from data obtained from data files of the Korea Listed Companies Association.3 1. 1994-1998 (percent) SFRa IDFR 85.4 1.3 Year 1994 1995 1996 1997 Average a Excludes capital surplus.6 IEFR 42.3 IDFR 57.2 36.3 86.8 22.6 70. Source: Calculated using data of Seung No Choi.5 91.28 Financing Patterns of Listed Companies.1 93.3 28.2 1.7 1.
and loans from NBFIs.0 207. and underdevelopment of the stock market.3 58. and reserves and retained earnings.1 — — — 1995 161. loans from banks. Third. in order of ranking.3 200. inefficient investment and excessive diversification of corporations. Controlling shareholders usually tried to avoid dilution in their shareholdings for fear of losing control. Financial institutions did not strictly screen their loan projects and monitor their debtors. and extended loans based on cross-payment guarantees. And fifth. poor financial and corporate governance resulted in overlending by banks.30 Cross-Payment Guarantees of the Top 30 Chaebols. Interest payments on debts were considered a loss when calculating taxes. bond issues.0 1997 91. Few firms ranked loans from NBFIs as their first preference.3 64. the Government provided implicit guarantees on bank lending and large businesses. company preferences in financing investment projects before the crisis were. bond issues. Factors Influencing Corporate Financing Choices Until recently.Chapter 2: Korea 127 Table 2. These are followed by loans from banks. First.7 150. Fourth. This change implies that firms now give more attention to financial risks. Second. the Government applied high tax rates on net profits of corporations. .9 — — — 1996 105.1 — = not available. chaebols could easily borrow funds from banks and NBFIs by using cross-payment guarantees.9 — — — 1994 258. Firms now prefer internal funds and new equity capital. According to the ADB survey. more than half of bank loans were priority loans with low interest rates. This attitude appears to have changed after the crisis because reserves and retained earnings and rights issues became the preferred financing choices. especially in the 1970s when real interest rates of bank loans were negative. Source: Fair Trade Commission and the Federation of Korean Industries. the Korean economy was plagued with high inflation.9 153. so that the firms engaged in lobbying to gain access to them. 1993-1997 (as percentage of equity capital) Rank Top Top Top Top 30 Chaebols 5 Chaebols 6-10 Chaebols 11-30 Chaebols 1993 469. Korean firms preferred debt financing (bank and nonbank borrowings). Further. rights issues. There were several reasons for this.
even with a heavy debt burden. and others (29 percent) expected the local currency to appreciate in value. and futures and other financial derivatives. many firms (or 42 percent) never considered hedging. the percentage of foreign currency denominated debt in the portfolio was 14. About half of the respondents of the ADB survey borrowed foreign currency denominated loans from foreign banks. II In seeking external financing. some (36 percent) thought that a hedging facility was not available or not working properly. 2. firms give their first consideration to minimization of transaction and interest costs. the majority (60 percent) of the firms responding to the ADB survey look first for nonaffiliated financial institutions. A futures exchange launched in 1999 trades foreign exchange options. For these firms. maintenance of the existing ownership structure. they survived for two to three . and reduction in tax burden. 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 1996.36 percent on average for these companies.128 Corporate Governance and Finance in East Asia. in selecting financing sources. Among the responding companies that had foreign currency denominated loans. The percentage of foreign currency denominated loans hedged against exchange rate risks was 21.5 percent at the end of 1997. Diversification. According to the survey. Korea now provides a better environment for financial risk management. 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. Vol. Among those that never hedged against exchange rate risks.4. Nonetheless. more than half (53 percent) hedged against exchange rate fluctuations. This preference has changed little after the crisis. These survey results indicate that many companies were not very attentive to exchange rate risks (and possibly to financial risks in general). Only a few firms sought foreign loans because domestic loans were not available. Other factors include. in order of importance. ensuring the liquidity of the company.3 Financial Structure. Few companies felt that hedging was too costly or was unnecessary as the exchange rate was considered fixed.
They were also higher than those of the top five chaebols until 1991. (1999) compared the financial positions of 504 chaebol affiliates and non-chaebol independent firms during the period 1986-1998. the top five chaebols and the top 6-70 chaebols had similar ratios. . However.3. 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. (iv) In terms of EBITDA to total assets.13).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.. In order to determine the relationship between financing patterns and corporate performance. 1999). Interest coverage ratios of non-chaebols were higher than those of the top 6-70 chaebols during the entire period. (i) In terms of total borrowings to total assets. but the ratios of independent firms were much lower.2. the trend was reversed in 1993 when the interest coverage ratios of the top five chaebols exceeded those of the independent firms. (ii) In terms of net income to total assets. But since 1992. except in 19931995 when semiconductor prices were extraordinarily high. the top five chaebols’ ratios were much higher. 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. The ratios of the top 6-70 chaebols were lower than those of the top five chaebols. Table 2. the ratios of independent firms were higher than those of the top five and top 6-70 chaebols during the entire period. the ratios of nonchaebols were remarkably higher than those of the top 670 chaebols during the entire period. Nam et al. These findings indicate that independent firms have had a lower leverage and performed better financially. (iii) Interest payment coverage ratios are calculated as operating earnings over interest expenses. except in 1991. Among the main findings were the following. as well as lax financial supervision (Nam et al. Operating earnings are earnings before interest payments and taxes plus depreciation and amortization (EBITDA). Those firms whose interest payment coverage ratios are below 1 are likely to go bankrupt.
Indicators such as increasing debt-to-equity ratios. But the net profit margins of the top 31-72 chaebols were higher than those of the top five in 1985-1992. then declined to levels lower than those of the top five in the years of economic downturn 1993-1997. The degree of diversification of chaebols that fell into default. Government intervention. second highest in the top 6-30. except in the recession years of 1996-1997.5 The Corporate Sector in the Financial Crisis This section looks at the various causes of the crisis in 1997. and composition was lower than that of the top 6-30 but higher than that of the top 31-72 chaebols on average. Vol. Meanwhile. Their subsidiaries. the top five chaebols outperformed the top 6-30 chaebols for most of 1985-1997. court receivership. Chaebols have been subsidizing new or low-profit industries by transferring resources from high-profit industries through inside dealings. or outright transfer of resources due to poor corporate governance practices. In terms of the net profit margin (the ratio of net profits to sales revenue). debt guarantees for free. The differences in the degrees of diversification among the three groups are substantial. its profit rate declined. 2. too. net profit margins of the top 31-72 chaebols were always higher than those of 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. The diversification of chaebols under workout was much lower than that of the top 6-30. This indicates that excessive diversification and inefficient investment of the top 30 chaebols resulted in relatively low net profit margins (Table 2. During 1985-1997. rising nonperforming loans (NPLs) and falling . had a significant role. and easier access to cheap credit.130 Corporate Governance and Finance in East Asia. however. Factors related to weak corporate governance were closely intertwined with shortcomings in macroeconomic policy and vulnerabilities in the financial sector. II Corporate Performance and Diversification As a chaebol further diversified into nonrelated areas.31). The diversification of the top five chaebols remained at about the same level within the period. had easier access to credit than the top 31-72 chaebols. the top 6-30 and 31-72 chaebols gradually increased their diversification beginning 1990. larger research and development expenditure. the degree of diversification was highest in the top five chaebols. and lowest in the top 3172 chaebols.
.5 1.9 1.3) 0.5) (2.7) 0.9) (1.2 (0.9 0.4 (2.8) 1.2) (4.6 (0.1) (6.2 (0.8 0.6 3. Background and Task of Structural Adjustment.1 (9.3) 0.2) 1.8 1.1) 1.2 (17.5 2.9 0.6 7.8) (37.7 — (0.2 1.3) 1.2) 2.2) (13.8) 2.6) 0.1 0.5 (0.0) 0.7 0.4 (0.9 1.6 1.4) (6.8 3.7) (1.4 1.3) (1.8 0.8 1990 0.0 1992 1994 1.7) (0.2 (0.9) 0.1) 0. Chung Ang University. 1985-1997 Item Top 5 Hyundai Samsung LG Daewoo SK Top 6-30 Top 31-72 Default.5 (0.3) 0.1 0.0 (7.1 2.4 0.3) 1.1) (2.2 (1.5 0.2 1.4) (0.3) 0.2) 1.2 1995 3.1 0.3 1.8) 1997 0.2) (0.6 1.8 0.5 (0.1 1.1 (4.9) 2.9 0.1 0.3 1.6 (0.0) (4.2 1.4 1.1 1.8) (11.3 (0. 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 (6.1) (5.6 1.8) (4.2) (4.6 0.9 0.2) (13.1) — = not available.3) 0.0 4.6 1.4) (2.4 1.3) 12.1 0. Source: Whan Whang.0 1.8 3.0 (2.7 (0.9 1.2) (0.4) (1.1 (3.6) (12.4) (1.3 1.3 1.7 1.2 0.6 1989 1.0 0.7) (0.7 0.7 0.1) (1.6 0.7 1.5) (2.1 0.2) 1.8) 0.1 1.1 1.4 1.8) (0.6 1.3) (0.3) (12.4 1996 0.31 Net Profit Margins of Chaebols.2 1.6) 0.7 2.5 1.11.6 0.9 (0.3 0.0) (0.2 4.6) (0.9) (8.1 0.5 1.8 0.4) (4.4 (0.7 0. Beyond the Limit.6) (20.8) (1. p.3 0.8) 0.7) 0.3 (0.1) 0.3 0.8) (20.8 0.3) 0.5 1.5) (0.1) 2.1 4.9) (9.2 (0.2 1.6) (0.7 (0.8) 0.3) (0.2) (4.2) (3.4 (1.5 1.4 (0.4 0.8 (0.7 3.3 0.0) 0.3) 0.9) 2.9) 2.7 1.5 (4.2) 0.4 0.0 1987 1. 1998.9 1.Table 2.5) 0.8) (1.5) (7.4 2.3 1.6 0.0) (0.3 0.3 1. Management Research Institute.0) 0. Court Receivership.0) (3.8) 0.3 (0.6 5.0 1.4 (1.7 (1.3 1.3 1.1 1.8 (0.3 (0.1) 1.6) 0.5 (0.1 0.6 0.3 1.2 1.7 (4.1 0.3 3.2) 2.4 (1.5 4.4) (1.0 6.6 (10.6 0.3 (3.8) 0.4 0.5) (1.8) (3.9 8.7 0.3 1.1 1.6) (12.8 1.1) (1.0 (0.7 1.1) 2.7 0.6 0.1 (0.0 0.8 (0.6) 0.1 1.1 (1.6 0.3 1.1 (4.
Until 1997.5. after the crisis. 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. Now. Thus. 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. . a firm’s board of directors had the power to appoint an external auditor. Meanwhile. Ownership concentration also had ramifications on corporate transparency. this has led to entrenched management. a committee composed of internal auditors. Along with government policies to protect the status quo. Until 1997. A remote trigger in the Thai crisis was all that took to push the economy over the edge. and to the development of the market for corporate control. 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.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. They were then almost automatically elected at the general shareholders meeting. outside directors. The Code of Best Practice recommends board audit committees for large listed firms and the Commercial Code is being amended to introduce the audit committee system as an alternative to the internal auditor system. the recently adopted Code of Best Practice in Corporate Governance recommends the strengthening of the board system. The hold was tightened by the practice wherein candidates for directors were handpicked from among the managers by the controlling shareholder. 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. But in 1998. Vol. 2. the boards of all listed companies were composed of insiders only. Thus. internal auditors cannot be expected to perform their function independently of management. The most serious problem among most Korean listed firms has been that a controlling shareholder acting as CEO could never be replaced. Moreover.132 Corporate Governance and Finance in East Asia.
profitable firms within a chaebol tended to subsidize unprofitable firms. Diversification can reduce chaebols’ risks through the portfolio effect. Under the direction of the controlling shareholder. These included restrictions of shareholdings of institutional investors. restrictions of voting rights of shares of institutional investors. usually a member of the founding family. prevalent window dressing practices. the Government maintained a policy of protecting the incumbent management of a listed company. 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. However. 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. Traditionally. Many of the takeover targets in the past did not have a controlling shareholder. There were no effective monitoring mechanisms for its management. and some differences in Korea’s generally accepted accounting principles from international standards. Dominance of Chaebols A chaebol is tightly controlled by the largest shareholder. One reason is that the percentage of inside shareholdings for an average listed firm is very high. a large issuance of preferred stocks with no voting rights. Banks did not function as monitors of corporate management although they were shareholders as well as the most influential creditors. when a large diversified chaebol. hostile takeovers in Korea will likely be rare in the future. and restrictions on hostile takeovers. participated in the stock market as short-term traders rather than long-term investors. 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.Chapter 2: Korea 133 There had been some devices to protect management so that companies could indulge in business activities without fear of takeover. however. Many changes were introduced to promote M&A in the 1990s. has an unsound capital structure and . individuals. regulatory and practical difficulty in implementing proxy voting. as a whole. as well as institutions. Meanwhile. corporate accounting information was not reliable due to the lack of independence of external auditors. In this situation. These internal dealings made strong firms weak and helped marginal firms survive.
the typical chaebol firm had an extremely high DER. and other individual markets.5. The new preference ordering is as .5. while (non-chaebol) independent firms had much lower borrowing ratios. and internal funds. the intervention later resulted in the accumulation of adverse side effects: underdeveloped product. financing choices of listed firms in order of preference were bank loans. As mentioned earlier. share issues. This effectively becomes an exit barrier for chaebols and would justify the intervention and support of the Government.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.3 Manifestations of Weak Corporate Governance and Government Intervention Preference of Debt Over Equity Financing in the Precrisis Period Before the crisis. Net profit margins of the top 31-72 chaebols were higher than those of the top five or of the top 6-30. although their subsidiaries had better quality workforce and easier access to cheap credit than the top 31-72 chaebol affiliates. and a high degree of inefficiency in the economy. the authorities did not properly check on banks’ lending practices—banks did not screen the lending projects and evaluate the creditworthiness of corporations properly. as the latter are well established in most business areas. II strong financial links among its member firms through investments and cross-guarantees. The Government and the Bank of Korea did not have accurate information on the extent of transactions that corporations and financial institutions had abroad. The Government’s supervision and regulation of financial institutions were poor.134 Corporate Governance and Finance in East Asia. 2. This indicates that too much diversification and overinvestment in the top 30 chaebols resulted in relatively low net profit margins. 2. bond issues. prevalence of rent-seeking and morally hazardous behavior by economic decision makers. the financial distress of one or a few marginal firms can lead to a chain of bankruptcies across the entire chaebol. Such problems may eventually cause ripples through the entire economy. Financing preferences changed drastically after the crisis. Vol. Profitability of the top 6-70 chaebol firms has been lower than that of the top five chaebol firms. However. capital. Further.
The lending practices of banks. Although the ratio of stock market capitalization to GDP in Korea was not very different from those in the Philippines and Thailand. the exchange rate (won/dollar) increased sharply and the financial crisis erupted in Korea.5 billion. total foreign debt amounted to $157. The high proportion of foreign debt led to a mismatch problem where borrowers were unhedged against foreign exchange risk.Chapter 2: Korea 135 follows: internal funds. The poor state of corporate governance in the banking and financial sectors was responsible for overlending by banks and NBFIs through perfunctory screening of loan applications. After the financial crisis erupted in Indonesia and Thailand. In November 1997. as evidenced by occasional. However. As of the end of 1997. obviously contributed to overlending and aggravated the situation. In the international financial market. 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. 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. bank loans. won/dollar nondeliverable forward rates increased rapidly. which were the most important financing source until 1987. . consisted of high proportions of policy loans. Implicit guarantees by the Government on bank loans to large businesses. which generally required guarantees or collateral. the top 30 chaebols showed a DER of 519 percent. signaling a bearish speculative move on the won. share issues. Other factors also contributed to this preference. which is far higher than the average ratio of around 400 percent for nonfinancial listed firms. This change implies that firms are now more attentive to financial risk and inefficient investment financed by external funds is less likely to recur in the future. the Government and the Bank of Korea defended the currency. The ratio of external debts to GDP reached 48 percent at the end of 1998. At the end of 1996. large-scale bailouts of financially distressed firms. The preference for debt finance also led to a relatively large foreign debt. Bank loans. overseas borrowing became difficult and higher interest rates were charged on foreign borrowing. Nonpolicy loans were also considered to be cheap because of interest rate regulations. reducing foreign exchange reserves to a dangerous level. and bond issues. The foremost reason why listed companies preferred debt financing over issues of new shares lies in the largest shareholders’ desire to keep control of the management by preventing dilution of their ownership. The financing choice of listed firms was also influenced by the underdevelopment of the stock market.
Fixed loans are those for which interest is not received for six months or longer. excluding the financial sector.000 from December 1997 to February 1998. According to the “six months” definition.136 Corporate Governance and Finance in East Asia. It jumped to 17. Financial Sector Vulnerability Because of financial losses in the corporate sector. and shareholders’ equity of all industries. The monthly number reached more than 3. The inevitable result of inefficient investment was a fall in corporate profits. and the pursuit of growth through excessive diversification and inefficient investment.200 in 1997. the ratios of net profits to sales. regardless of whether it is caused by large personal holdings of the controlling shareholder or by pyramiding.6 percent in June 1998. However. legal and other barriers prevented the exit of financially nonviable firms. Further. II Inefficient Corporate Investment and Low Profitability Ownership concentration among Korean firms.32). especially chaebols. they are defined as loans for which interest payments are overdue by three months or more. Moreover.7 percent in 1997. the NPL ratio reached 7.000 in September 1998 (Table 2. and there is collateral.1 percent in 1996.000 per year starting 1992. The bank supervisory 8 NPLs of banks comprise fixed (substandard) and doubtful loans.000 during January-September of 1998. The banks and merchant banks lent to large businesses. and returned to about 1. total assets. These were the definitions until 30 June 1998. nine out of the 30 top chaebols failed. the NPL ratio8 of banks and other financial institutions began to increase. and estimated losses. reaching highs of 6 percent in 1997 and 8. has given rise to various types of self-dealings by the controlling shareholder. the NPL ratio of commercial banks increased rapidly from 4. Vol. and there is no collateral. The number of insolvent companies increased rapidly in 1991 and doubled to more than 11. a large number of construction companies failed due to the recession in the real estate market and decline in real estate prices. Before the crisis. without strictly evaluating the creditworthiness of businesses and the profitability of projects. In 1997 they became negative. Following the “three months” definition. 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. . Doubtful loans are those for which interest is not received for six months or longer. starting 1 July 1998. were low in 1996 and 1997. decelerated from March 1998. Meanwhile. They utilized mutual payment guarantees among their affiliates and believed that they would never fail. The Government could hardly help them because of the number and magnitude of business failures. then 20.
417 Others 152 132 108 97 88 161 326 252 274 302 553 861 952 Note: 1998 figures cover only January-September.754 3.238 4. and declined to 4-6 percent in 1994-1996 (Table 2. Source: Bank of Korea. This speculation was said to be one of the causes of the financial crisis in Korea. those of domestic banks were lower in the 1990s.992 11. This was mainly due to the high ratios of NPLs. In 1990-1993. Meanwhile.133 3. ROEs and ROAs of Korean and Japanese banks were low compared with those of the US.China. the ratio reached 7-8 percent. As a result they had largely overvalued currencies.855 6. 2.32 Number of Firms with Dishonored Checks.135 1.259 2.985 Services 3.589 171. The current account deficits in terms .107 6.979 8.553 3.4 Shortcomings in Macroeconomic Policy The macroeconomic framework also contributed to the crisis in 1997. 1986-1998 Year 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total 4. authorities were not too concerned about the high NPL ratios at Korean banks in 1997 simply because the high and rising ratios had precedents. low efficiency.159 10.Chapter 2: Korea 137 Table 2. Exchange rates were virtually pegged to the US dollar in all troubled Asian countries.053 5.027 Manufacturing 1.255 13.673 Construction 380 354 242 195 294 585 1.265 6. 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.5.657 3.131 1. Policymakers thought that economic growth would resolve the NPL problem without the need for corrective action.890 4.69 20.647 8.856 7.637 6.859 3.573 3. and large government-directed loans.544 2.250 2.850 3.457 2.517 2.386 5.502 11.114 811 706 696 866 1.759 6.769 9. and continuous and large current account deficits.244 3. European countries. Compared to ROAs and ROEs of domestic branches of foreign banks.472 2.210 1.33). and Taipei.751 1.
Meanwhile large businesses could not legally lay off workers. Real interest rates in Korea had been two to three times higher than those of Japan or Taipei. Vol.0 8. which led to large corporate losses. the hourly wage rate in the Korean manufacturing sector was higher than in Singapore or Taipei.China. Korea -4. Thailand -8. Mass layoffs became legally possible only after the economic crisis. judging from the real effective exchange rate indexes using unit labor cost indexes as a deflator and 1985 as a base year. The pegged currency also encouraged foreign borrowing as investors believed that the exchange rate would remain stable.116 1.160 11.2 4. It was estimated that the Korean won was overvalued by 20 to 30 percent from 1989 to 1997. Source: Bank of Korea.1 7.832 337.266 10.176 7.237 Estimated Loss (C) 958 920 840 816 213 385 490 490 648 NPL (A+B+C) 7.1 6.929 11.138 Corporate Governance and Finance in East Asia. of percentage of GDP were as follows: Malaysia -8.649 375. because of the rigid labor market.639 1. Related to this.430 12. the terms of trade deteriorated 12 percent in 1996 and 11 percent in 1997.556 118.584 2.736 8. In addition to the overvaluation of the won.33 Nonperforming Loans of General Banks.997 9. and 30 percent in 1996. Land prices and real estate rents were also high compared to trading partners. . 1990-1998 (W billion) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 a Total Loans 90.221 8.520 194.584 Fixed (A)a 5. II Table 2.190 9.077 NPL Ratio (%) 8.6 Fixed loans are those requiring collateral and for which interest is not received for six months or longer.475 143.4 5.0 7.310 6.1 percent (1995).0 7. Businesses served as a social safety net.827 289.537 10. The main result of the rigid labor market was a “high-cost and lowefficiency” economy.6 percent (1995).874 22. although per capita income in Korea was much lower.562 18.390 12. and Indonesia -3.484 11.705 160.739 241. the ratio of short-term debt to foreign reserves was very high. b Doubtful loans are collateral-free loans for which interest is not received for six months or longer.192 Doubtful (B)b 952 1. even in times of economic slowdown.8 percent (1996).910 1.954 9.600 10.8 5. In 1997.China.652 29.170 1.6 percent (1995).
. embarked on their own restructuring programs and/or implemented restructuring demands of the creditor banks. ‘Voluntary’ Restructuring Chaebols have been under pressure from the Government to abolish their informal group headquarters to increase the managerial independence of member firms. A guideline informally promulgated by FSC required the 30 largest chaebols to lower their DER of 412.6 percent as of the end of June 1998 to no more than 200 percent by the end of 1999.1 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.Chapter 2: Korea 139 2. The FSC—later called the Financial Supervisory Service (FSS)— which is in charge of prudential regulation of financial institutions. Corporations. 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. and subsidizing money-losing units. Ailing banks needed to be recapitalized after the huge amount of NPLs was disposed.6. Other firms experiencing financial distress were subjected to workout procedures through negotiations between debtors and creditor institutions. which were laden with huge amounts of debt and were on the verge of bankruptcy. has been actively utilizing its influence to motivate institutions to coordinate debtor firms’ restructuring activities.6 2. 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. the excessive amount of debt of Korean corporations had to be reduced to a sustainable level. To achieve this. However. Nonviable firms and financial institutions. Measures have been taken by several chaebols to streamline operations and improve incentives of managers and employees. Downsizing by curtailing employment has been prevalent. They have been pressured to stop such practices as providing loan guarantees. had been forced into bankruptcy proceedings or merged into healthier entities. including banks. the immediate objective centered on restoring the international investment community’s confidence in the Korean economy.
banks and other creditors were reluctant to absorb losses realized by debt compositions. More than 59 percent of potential buyers were foreign firms. In many cases. 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.140 Corporate Governance and Finance in East Asia. 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. potential foreign buyers waited for the price of acquisition targets to come down further. 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. Vol. Banks did not have the incentive to force financially nonviable firms to liquidate. Noticing this disincentive. In their first review. Involuntary Exits The Government has been involved in the restructuring process mainly through its supervisory capacity over banks.281 in April to 2. The reasons are manifold. because liquidation of debtor firms would exacerbate the banks’ already weak balance sheets.138 by the end of October. or to agree on debt-equity swaps demanded by potential purchasers as a precondition for the deal. On the other hand.045 in October. they were reluctant to allow recontracting for fear of further deterioration in the capital adequacy ratio. the creditor . Internationally. 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. Korean firms have been slowly stepping up their restructuring since the latter half of 1998 as the economy began to show signs of recovery. the number of potential sellers decreased somewhat from 2. More important. It was frequently observed that the negotiating parties could not agree on a price due to large discrepancies in valuation. Locally. The data also show that about 24 percent of acquisition negotiations ended up in actual deals. while only 14 percent of the negotiations were completed from the beginning of the crisis up to April 1998. This number was at 779 firms in April and grew to 1. II Divestitures to raise cash for debt reduction and to focus on core businesses have not proved to be easy. FSC directed banks to appraise the long-term viability of client firms showing symptoms of failure.
but viable. The plans were put into action immediately following finalization. was allocated to the six largest banks for them to employ outside experts as advisors. Also. 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. provided by the World Bank. By the end of 1998. workouts are being applied to non-chaebol firms identified as financially weak. and 12 were sold off to other firms.Chapter 2: Korea 141 banks selected 55 firms as targets for exit. not only for the design of corporate workout programs but also their implementation. 24 were liquidated. creditor banks completed evaluation of the financial status of 35 subsidiaries belonging to 13 chaebols. the creditor banks drafted their own restructuring plans with assistance from outside advisory groups led by foreign investment banks. three filed for courtsupervised bankruptcy reorganization. Corporate Workouts Workouts in the forms of debt rescheduling. and 16 non-chaebol corporations that had been selected as possible workout candidates. Although the intention of the Government and the banks was to effect immediate liquidation of these selected firms. FSC has been monitoring the processes from a prudential regulation standpoint. Among the sell-offs. A portion of the Technical Assistance Loan of $33 million. More than 200 financial institutions signed the Corporate Restructuring Agreement to carry out corporate workouts with the top 6-64 chaebols. These chaebols submitted plans for restructuring to improve their respective capital structures. two were acquired by newly organized employee stock ownership plans. Negotiations were then held between the chaebols and the creditors’ councils to finalize the financial structure improvement plans. the results thus far have not entirely been as desired. . These included 20 firms from the top five chaebols and 32 from the top 6-30 chaebols. by their creditors. Upon completion of the evaluation. write-offs. The workout plans were completed for most firms by early 1999. Based on these plans. 11 were merged into other group members. and/or conversion of debt into equity have been applied to those firms that are considered to be viable in the long run and have voluntarily entered into negotiations with creditor banks. interest reductions. The creditor banks and the advisory groups also drafted such plans for the top 6-64 chaebols. Among the 55 firms selected.
Restrictions on foreign ownership of land were also abolished. On 3 September 1998. In another. automobiles. Hyundai Motor Corporation won the international auction of Kia Motors in its third bidding and Daewoo Motors agreed to acquire Samsung Motors. Korea adopted and implemented policies to open its capital market completely. First. the Government has been urging the largest chaebols to strike “big deals” or business swaps among themselves to consolidate overlapping manufacturing facilities. labor union demands of the seller were not acceptable to the transacting parties. oil refineries. purchase of divested assets. uncertainty over the future . This figure contrasts sharply with the total of $700 million for all of 1997. vessel engines. most of the big deals have entered their final stages of negotiation. Big Deals Ever since the outbreak of the economic crisis. railroad cars. aircraft. In the case of automobiles. the foreign buyer demanded specific protections against adverse developments in the business environment. chaebols did announce their agreements on big deals in seven industries excluding the automobile industry.142 Corporate Governance and Finance in East Asia. Thus. In one case. Big deals have been elevated to the status of the most important means of effective corporate restructuring. Foreign Acquisitions Confidence in the Korean economy depends critically on the lowering of the level of corporate debt. Vol. Big deals would. II creditor banks and the corporations will devise detailed workout programs based on the rehabilitation plans submitted by the corporations. power plant facilities.5 billion on agreement basis during the 10-month period after December 1997. and petrochemicals. enable chaebols to streamline their overly diversified operations and focus on several core business areas. The less than satisfactory state of foreign capital infusion in the early days stems from a number of factors. These deals could eliminate excess capacity in such industries as semiconductors. inducement of foreign direct investments was considered to be the most effective means of achieving that end. As of April 1999. it is hoped. However. and equity participation—reached about $8. some of the acquisition agreements have been discarded for various reasons. Foreign investment—in the form of acquisition of controlling interests. In the early days after the outbreak of the crisis.
(ii) to remove cross-guarantees of loans among group members. Fourth. 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. Fifth. the Government and chaebols reached an agreement on the goals of restructuring and reform efforts. these goals were: (i) to enhance managerial transparency. Third. 2.2 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. local creditor banks were reluctant to absorb losses arising from debt compositions and debt-equity swaps that were necessary in deals involving insolvent sellers. As set forth in the agreement. and (v) to improve the accountability of controlling shareholders and the board. the improved procedures stipulated in the Bankruptcy Reorganization Act and the Composition Act reduced what had previously been legalistic exit barriers. foreign buyers usually employed discounted cash flow methods of valuation while local sellers often put greater emphasis on replacement costs of assets. (iii) to reduce financial leverage. Sixth. Overhaul of Bankruptcy Procedures In February 1998.Chapter 2: Korea 143 course of the Korean economy remains high. (iv) to focus on a small number of core businesses. The presence of . In effect.6. some of the potential acquirers demanded terms that were unreasonable or unacceptable from the sellers’ point of view. Second. 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. Not only does this represent progress in terms of an improved institutional framework for market competition. many of the businesses that Korean firms put on sale did not prove to be attractive to foreign firms. 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. With this in mind. foreign buyers were concerned with the inflexibility of the labor market. Seventh. but it also has important implications with respect to corporate workouts.
and economics professions should be organized to provide for expeditious proceedings in court. (iv) restrictions on institutional investors’ voting rights were eliminated in June 1998. In the past this stage usually extended for as long as two to three years. 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. The court can refuse to accept the application for composition if it finds it inappropriate considering the size of corporate assets. (iii) the representation requirement for shareholder derivative suits was drastically relaxed from 1 percent to 0. etc. 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. number of creditors. if a final reorganization plan is not worked out within one year from the date of the court order placing a firm in receivership. the court may annul its previous decision and force the firm into immediate liquidation. Korea’s Economic Progress Report. the maximum grace period on loans to the firm being reorganized was shortened to 10 from 20 years. the right to revoke court receivership is allowed to the creditors. Third. accounting. October 1998. The purpose of this rule is to shorten the reorganization planning period. The creditors can form a “Creditors Committee” among themselves to allow them to participate in the decision processes in court. thereby preventing abuses by controlling shareholders/managers of financially distressed firms. (ii) legal changes have been made so that domestic accounting practices conform to international standards. Second. a “Management Committee. Also. Also. . the Composition Act was amended to narrow the eligibility of applying for court-supervised composition. Fourth. (v) all listed companies are required to appoint outside directors beginning 1998 9 This and the following two subsections draw on the Ministry of Finance and Economy. II an expeditious exit scheme is expected to better induce negotiation for workouts between creditor banks and corporations. First. Fifth.” comprised of experts in the legal.144 Corporate Governance and Finance in East Asia. Vol.01 percent in May 1998. the changes in the institutional setting for corporate reorganization will enable creditors and debtors to promptly respond to the development of financial problems.
Capital Market Liberalization Since 1998. which was passed in August 1998. (iii) hostile mergers and acquisitions by foreigners were fully liberalized in May 1998. In addition. 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. crossdebt guarantees totaling about W10 trillion—about 30 percent of the total guarantees among the 30 largest chaebols—were dissolved. According to the law. have been instituted for FDI: . Existing cross-debt guarantees should be completely eliminated by the end of March 2000. an additional nine industries will be opened or further liberalized. and (viii) as of 1 April 1998. (ii) full liberalization of foreign exchange transactions was legislated and will be put into effect in two stages. As for promotion. 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. (vii) by the end of March 1998. including financial subsidization. These new standards are and will continue to be strictly enforced. beginning on 1 April 1999. either partially or fully. 21 industries were further liberalized or newly opened to FDI (now.148 industries remain closed. Measures for improving standards in corporate governance are already effecting a generally more open corporate culture and greater transparency in business practices. only 31 out of 1. including tax exemptions and reductions. to FDI). various supporting measures.Chapter 2: Korea 145 (as of the end of May 1998. (v) by the end of May 1999. financial institutions could no longer require cross-debt guarantees. administrative procedures for FDI will be dramatically simplified and made transparent. the Korea Trade and Investment Agency (KOTRA) will provide a one-stop service with respect to FDI. (vi) bankruptcy laws were revised in February 1998 to facilitate the exit of insolvent firms. (iv) during April and May 1998. 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. Foreign Investment Promotion Act The Foreign Investment Promotion Act was put into effect in November 1998. 514 listed companies had appointed 677 outside directors). Foreigners are now able to invest in local bonds and short-term money market instruments without any restrictions.
as well as building an early warning system. Various local taxes will also be exempted or reduced for eight to 15 years at the discretion of local governments. To minimize potential risks. II (i) (ii) (iii) Tax exemption and reduction: Corporate and income taxes will be exempted or reduced for FDI in target industries. are not risk-free. for 10 years (full exemption for the first seven years and 50 percent tax reduction for the remaining three years). 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. Vol. The location of the FIZ will be determined at the request of foreign investors. The primary aims of the law are the liberalization of the capital account and the development of the foreign exchange market. Various support measures. such as the high-tech industry. It aims to establish a benchmark by consolidating various government bonds. Capital Market Augmentation Bond Market The Government recently introduced a policy plan to deepen Korea’s bond market. Three-year government bonds will be used to establish a benchmark. These bonds will be issued . the Government intends to supplement these measures with a sound macroeconomic policy in order to secure more effective protection against systemic risks. however. 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. Also. The law allows rental cost exemptions and reductions for FDI. including infrastructure and tax support. The majority of government bonds to be issued in the next two to three years will carry a maturity of three years. These liberalization measures. the Korean Government is strengthening prudent regulations and market monitoring. Free Investment Zone (FIZ): A free investment zone will be developed to accommodate large-scale FDI.
a debt restructuring fund and three balanced funds (funds that invest in both equity and debt) were established in September 1998. Asset-Backed Securities A new law providing for asset-backed securities (ABS) was passed in September 1998. including the Korea Development Bank. Prior to the introduction of this system. Moody’s signed a joint venture contract with Korea Investors Service. invested a total of W1. both domestic and foreign. commercial banks were allowed to carry out dealing operations for government bonds starting in October 1998. According to the law. and is promoting joint ventures between foreign and domestic agencies. This law will not only provide an effective institutional environment for the disposal of NPLs. It also opened the credit rating service market to foreign competition. These are expected to operate for the next three years. with only minor standard exceptions. but it will also help improve financial institutions’ risk management. Related legislation was put into effect in September 1998. In order to promote a greater market demand for government bonds.6 trillion for the debt restructuring fund. If interest rates stabilize at a low level. To ensure transparency and efficiency of the fund operations. No qualification requirements are being imposed on investors who are sponsoring new mutual funds. Mutual funds (or open-end investment companies) will be allowed starting 2001. financial institutions . As a pilot program. but may be extended as required. to establish closed-end investment companies.6 trillion in these funds: W0. a primary dealers system will be introduced for healthy financial institutions. Twenty-five domestic financial institutions. 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. It is now easy for private investors.Chapter 2: Korea 147 monthly. The Government established specific qualification criteria and selected the primary dealers in 1999. the Government will correspondingly expand the issuance of government bonds that have a maturity of five years or more. and W1 trillion divided equally between the three balanced funds. and the demand for longerterm bonds increases in the future. In August 1998. they will be managed by foreign investment management companies.
148 Corporate Governance and Finance in East Asia. One way of strengthening independence of the boards is to require that listed companies accept nominations for directors by institutional . Policies aiming to improve the corporate governance system should take into account the high ownership concentration often created by pyramiding. However. such as the Korea Asset Management Corporation (KAMCO). A investing in B. However. foreign business corporations with good credit standing are now also permitted to issue ABS. etc. II and qualified public corporations.3 Policy Recommendations Poorly performing markets and the resulting lack of market discipline justified the government intervention in recent corporate and financial restructuring activities. then the regulation will inhibit efficient investment of firms. and C investing in D. 2. the role of the board of directors as the internal control mechanism must loom large in corporate governance. as stipulated by the government measure. More important. can utilize ABS.. The corporate governance structure cannot be expected to function efficiently if this issue is not addressed. is inevitable. which is the case for many chaebols. A good governance system is essential for the healthy growth of corporations and financial institutions. As markets become more efficient. 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. 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. cross-subsidization. For instance. Direct controls of interfirm investments and/or pyramidal ownership structures will not be persuasive. B investing in C. There must be stronger rules to control agency problems.6. However. when the limit is binding. unless the limit is tight and binding.g. In principle. the government intervention will have to be refocused so that it only sets the rules of the game in the marketplace. Vol. Selfdealings. this can only be a temporary measure. considering that there is no other effective way to limit circular investments among chaebol affiliates (e. It would be more desirable for the market-oriented measures to be put into place and strictly enforced. this regulation may not be effective in curtailing pyramidal structures. greater efforts to improve corporate governance are preferable to regulation of interfirm investment. there is another view that placing a maximum limit on interfirm investments.) and the level of interfirm investments is very high. On the other hand.
Listing rules may recommend that all or large listed companies adopt an audit committee. Further. various measures have been implemented to promote investors’ rights. thereby helping to strengthen board independence and enlisting boards’ more active involvement in monitoring corporate management. Institutional investors will play an increasingly important role in corporate governance. Latham.Chapter 2: Korea 149 investors or their trade associations. pp.10 Other means to improve independence of the boards include mandating that independent outside directors form the majority. 1997). and requiring that all directors hold shares of their companies. it will have to include making self-dealings by directors and officers. 23-26. and also negligence of external (independent) auditors actionable. using audit. governance. One way of motivating institutions to do this is to 10 M. 1997. The annual shareholders meetings could also elect reputable “monitoring companies” to recommend director candidates (Latham. Each listed firm should be required to disclose the extent of its compliance with the Code in its annual report. 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. the Korea Stock Exchange could incorporate provisions of the Code of Best Practice in Corporate Governance in its listing rules. September/ October 1997. Class action suits are an efficient means for corporate monitoring. More effective measures to protect investors will enhance corporate transparency and also the accountability of directors to shareholders. Proposed: A Governance Monitor. . The Corporate Board. The Securities and Exchange Act will then require large listed companies to switch to a board audit committee system from an internal auditor system. Since the economic crisis. 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. 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. and other committees. 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. If and when the law is introduced. The Government can prompt institutional investors to contribute more to good corporate governance by paying greater attention to corporate affairs.
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. Vol. important pension funds including public employee funds and teacher funds seem to have their own governance problems because their top management and portfolio management policies are controlled by the Government. and impose stronger penalties on violations of the rules on portfolio investments. II provide comprehensive guidelines for their actions in matters related to corporate governance. 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. more drastic in nature. Another measure. an audit committee. strengthening incentive compensation schemes for executives. could prepare such guidelines. reviewing independence and expertise of candidates for outside directors. The institutions’ respective trade associations. strengthen its supervisory activities. The Government can also lower the limits on investments in affiliated companies. 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. possibly. and other NBFIs are subsidiaries of chaebols— especially the five largest ones. . securities companies. In the coming years. and thus cannot be expected to be actively involved in monitoring portfolio firms. such as the Korea Investment Trust Association. objecting to certain defensive measures proposed by the management. and compliance officers. These guidelines would recommend shareholder activism and faithful discharge of fiduciary duties by actively participating in shareholder voting. The Government recently proposed the revision of bankruptcy-related laws. by all nonfinancial companies (or “industrial capital”). Application of more stringent bankruptcy-related rules to firms in financial distress will effect greater discipline over corporate management. Shareholdings concentrated in investment companies and other institutional investors pose a serious dilemma. is to restrict ownership of investment trust companies and NBFIs by the five largest chaebols and. Rights of minority shareholders should also be strengthened for these institutions. Also. etc. 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. Many of the larger investment trust companies. insurance companies. the Government will have to come up with appropriate policy measures to solve these problems.
which could provide alternative sources of long-term corporate finance. The Government needs to sell off at the earliest feasible dates the bank shares that it acquired in the course of recapitalizing banks. (ii) provision of reliable accounting information. the banks have great leverage over the management of debtor firms. and introducing disincentive schemes for excessive borrowings. and financial institutions. To facilitate the development of the Korean stock market. and consistently show low profit rates. The current obligatory system of disclosure that emphasizes “hard” . This means that the Government can control the banks and. lessening the degree of double taxation of dividends (or further reducing personal income taxes on dividends). For this. The Government should put more efforts into developing the capital market. reduction of protection of domestic markets and entry barriers. large firms. the limit on ownership of bank shares will have to be eased so that strategic investors (shareholders) can act as true effective monitors of bank management. and stop unfair internal transactions. In order to minimize government intervention in bank and corporate management. The Government should substantially reduce the proportion of policy loans from bank loans. the important issues to be addressed are: (i) improvement of the corporate disclosure system. Chaebols are overly indebted. therefore are vulnerable to economic shocks. Bank boards also need to be made more independent from management. In turn. through them. private firms. Many corporations are burdened with excessive debt and. Such measures include providing an effective corporate governance system. Banks need to play a bigger role than they do at present in monitoring corporate investment and management. Banks should adopt strong incentive compensation schemes for management. to concentrate instead on a small number of core businesses. Many concepts regarding good corporate governance are still new to a lot of market players in Korea. and (iii) a good corporate governance system to protect investors. An effective policy package is needed for chaebols to dispose of marginal firms with low profitability at the earliest date. The public and corporations should be taught or fully informed of the best practices in corporate governance. the elimination of implicit guarantees for financial support to chaebols. and thus full-scale education programs should be developed. such as application of higher interest rates by banks to chaebols with higher DERs. bank managers should be made accountable to shareholders but not to the Government.Chapter 2: Korea 151 There still exist widespread concerns that the Government will continue to exercise a great deal of discretionary power over banks. excessively diversified into nonrelated business areas.
is considered to be one of the major causes of the economic crisis. 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. no economic reforms will be effective. the information system of the bond market should be better organized to transmit. The development of the OTC bond market requires a well-developed dealer system. and labor productivity should be considered. The network should cover not only the exchange market but also OTC transactions of investors and dealers. and bureaucrats. Another problem with the corporate bond market is that most bonds are issued with maturities of less than four years. penalties on violations of disclosure rules are not effective enough to have a significant impact. The function of securities companies as dealers of bonds should be improved.152 Corporate Governance and Finance in East Asia. These should be lengthened to make them a source of stable long-term funds. wage rates. At the same time. II information on past performance needs to be transformed into a system in which corporations voluntarily announce “soft” information on future prospects. . on a real time basis. 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. Future research could include causes of corruption. Vol. Currently. and measures to reduce corruption. data on quotations and trading volumes. reasons for different degrees of corruption in various countries. More effective punitive means need to be devised to penalize both corporations in violation of disclosure rules and the officers in charge. In determining optimal exchange rates. Prevalent corruption. politicians. Without successfully addressing this problem. especially among business people. Policies are needed to help develop more reliable services by bond rating agencies. Maintaining current account surpluses for a considerable period is needed to pay back foreign debts. The establishment of a Corruption Prevention Institute will be helpful in this regard.
Survey of Facility Investment Plan. S. 79-95. Kang. K.). Korea Development Bank. Is the Fair Trade Policy Fair? Korea Economic Research Institute. S. and K. W. Latham. edited by K. pp. Economic Statistics Yearbook. H. September 1997. Evolutionary Chaebol. KERI. S. Jua. Korea’s Large Conglomerates. C. 1996. Y. I. Hong. W. A Study on the Relationship between Ownership Structure of a Firm and Value of a Firm. Jae Woo. Financial Statement Analysis Yearbook. Kim. N. W. 1993. H. 1997. Choi. Market Concentration and Diversification of Business Groups. pp. September 1998. Kim. KERI. W. Lee. Kim. Financial Studies. 1995. Chon. S. Cho. 1989. 1992. September/October 1997. in Korean Managerial Dynamics.. various issues. and 1998 issues. Maeil Daily Economic Newspapers. Korean Managerial Dynamics. Lee. H. H. 1998. International Financial Statistics. An Empirical Evidence on Value of a Firm and Ownership Structure.Chapter 2: Korea 153 References Bank of Korea. Chung and H. Bibong Publishing Co. Japanese Zaibatsu and Korean Chaebols. S. 1995. Korea’s Financial System. H. D. Determinants of Diversification of Korean Business Groups. Tomio. Cho. various issues. Korea’s Chaebol. C. various issues. Korea Economic Research Institute. Proposed: A Governance Monitor. 1998. M. 1989. Chon. 1997. Center for Free Enterprise. New York: Praeger. The Corporate Board. KERI. Ju Hyun. 1997. 7995. and J. 1999. September 1998. Financial Studies.. K. Bank of Korea. Lee. 1997. and H. 1996. Understanding Flow of Fund Accounts. New York: Praeger.. Chung. pp. 23-26. Bank of Korea. Hattori. C. T. D. . 1994. I. 1996. International Monetary Fund. Lee (eds. various issues. Korea Economic Research Institute. S. Corporate Restructuring. Bank of Korea. Kwon. Hong Moon Sa.
II Lee. 1996. Y. S. October 1998. 1999. C. Whang. and J. S. Joh. October 1998. U. H. I. A New Trade and Industrial Policy in the Globalization of Korea. Ministry of Finance and Economy. Vol. K. Korea’s Economic Progress Report. 1998. J. Whan. Capital Liberalization. Lee. Wang. 1996. March 1999. Management Research Institute. 1998. Real Exchange Rate and Policy Measures. Ungki. Y. The Pattern of Ownership Structure and their Characteristics in Korean Conglomerates: With Cases of the 30 Largest Chaebols. Sohn. Korea’s Trade and Industrial Policies: 1948-1998. Lim. Chung Ang University. S. Yonsei University. S. Kang. 23. K. Korea Finance Institute. Corporate Governance in Korea. I. January 1995. Seoul. Background and Task of Structural Adjustment. Lee. 1995. and H. Korea Development Institute and World Bank. Beyond the Limit. Yang. KIET Occasional Paper No. W. 1998. Korea Institute for International Economic Policy. September 1998. Kim. J. 1998.. J. Korea Institute for Industrial Economics and Trade. Kim. Korea Institute for International Economics and Trade. Lim. . Business Groups in Korea: Characteristics and Government Policy. 2nd Sangnam Forum.. H.. Ungki. K. Y. C. KIEP Working Paper 98-05. Chicago. 1999. Yim. Annual Conference of Financial Management Association.154 Corporate Governance and Finance in East Asia. and J. Nam. November 1996. Conference on Corporate Governance in Asia: A Comparative Perspective. The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols.
the PSR Consulting. state-sanctioned monopolies. for their research assistance. allowed the Government and the corporate sector to gradually access foreign debt markets after a long absence. Denise B. about a decade before the recent Asian crisis. and government subsidies were tackled during that period. and Liza V. the Philippine economy and corporate sector were in a relatively sound financial position. the Philippine nonfinancial corporate sector had managed its borrowing risks relatively well by largely avoiding imprudent use of debts and risky investments. PSR Consulting. From 1993 to 1996. This has come about following a political and economic upheaval from 1983 to 1987. Issues such as State ownership of businesses. in particular Francisco C. the Philippine corporate sector has played a leading role in the government’s efforts to get the country on track toward sustainable economic development. David Edwards. overall. Pineda. the Philippines. Serrana. and Lea Sumulong and Graham Dwyer for their editorial assistance. Inc. 1 Principal. The lifting of the debt moratorium in 1991. 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. When the Asian crisis erupted in 1997.3 The Philippines Cesar G. Roble. Saldaña1 3. the Philippine Stock Exchange for its help and support in conducting company surveys. Inc. staff. . Companies of other Asian countries were already using these markets to finance investment and growth. after the completion of debt negotiations with the IMF and Paris Club. both of ADB. The Asian financial crisis revealed that. The author wishes to thank Juzhong Zhuang.. aiming at eventually limiting the Government’s role to economic policy setting and allowing the private sector to conduct most economic activity. 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). and David Webb of the London School of Economics for their guidance and supervision in conducting the study.1 Introduction In recent years.
control by internal and external governance agents. Vol. 3. patterns of ownership. emerged to influence industrial policies.2 3. II Still. companies were necessarily large and capital-intensive. Investments of large corporate groups tend to focus on obtaining market shares and industry dominance. on family-based and controlled conglomerates. The policy was crafted by the martial law regime at that time. composed mostly of families previously in trading businesses. therefore. which leads to their easing of due diligence and monitoring standards when lending to group members.2. their growth could not be sustained.156 Corporate Governance and Finance in East Asia. But protectionist policies made labor relatively more expensive and. While new manufacturing industries were successfully established. and responses to the financial crisis. patterns of financing. Companies finance long-term investments with short-term debt. These early industrialists naturally opposed any initiative to reduce tariffs. the Government overvalued the local currency and imposed high import tariffs.1 Overview of the Corporate Sector Historical Development During the 1950s and 1960s. regulatory framework. The highly concentrated and family-based ownership of corporate groups has resulted in governance structures that depend largely on internal control systems. It analyzes the impact of corporate governance on company financial performance and financing. yet they did not risk new capital required for modernizing and expanding manufacturing capacity. This study reviews the Philippine corporate sector in terms of its historical development. An industrial elite. Banks have significant presence as members of affiliated business groups. and on the financial crisis. Corporate financing relies excessively on bank loans. To implement these policies. Sugar refining and textile mills are examples of industries that floundered in the 1980s because of government import substitution policies. Government interventions under the notion of “master planning” for economic and social development characterized the 1970s and early 1980s. the corporate sector showed structural weaknesses similar to those in neighboring Asian countries. usually with the acquiescence of bank creditors. nationalist sentiments led to policies that favored import substitution and heavy government intervention in business. Companies were profitable because of protection from foreign competition. The Board of Investments (BOI) was created to draw up an investment priorities .
. and oriented toward exports.Chapter 3: Philippines 157 plan (IPP) to encourage private sector investments by offering tax and other incentives.e. made less associated with capital investments. The FIA allowed foreign equity investment in many areas and at the same time provided a transparent. the “pioneer” industries identified in the IPP. Foreign ownership was allowed only in industries with high technological and market barriers. In 1991. The high industrial concentration led to practices of price leadership and output restrictions and the rise of industry lobby groups—common features of an oligopolistic . quantitative restrictions. the Government narrowed the range of tariff rates by commodity categories and reduced the average tariff rate from 28 to 20 percent. the legislative body passed the Foreign Investment Act (FIA). organizing industries into sectors and picking “winners. Following government initiatives in the control of the infrastructure and utilities sectors. assumed ownership of the largest petroleum refining company. the State took over the generation and distribution of electricity. dominance by large companies. The Government signaled through the IPP its intent to shape the future industrial landscape. Exports were not competitive because of the high costs of imported materials. Starting in 1981. including the reduction of tariffs. advance notice of areas where the country disallowed or restricted foreign investment. The 1980s were marked by a peaceful transition of political power. In many industries. the Government continuously revised the enabling law of BOI so that incentives were reduced in number. It limited the bureaucratic cost and discretion that accompanied the necessary approvals of foreign investments. clearly shifted economic management toward reliance on markets rather than on decisions by bureaucrats in the Government. BOI incentives retained a strong bias in favor of capital-intensive enterprises and domestic-oriented industries. Better access to cheaper imported raw materials improved the competitiveness of local manufacturers. the top three companies accounted for a disproportionately large share of total sales and assets. and import licensing requirements. In the early 1990s.” No strategic industry could take off without the Government’s participation in its management and operations. i. Quantitative restrictions and tariff protection of preferred industries remained firmly in place. Nevertheless. 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. and initiated the development of alternative energy sources in response to the oil crises. and orientation toward domestic markets.
5 (7.2 During 1988-1997.4 4.2 Growth and Financial Performance Performance of All Companies The analysis of corporate performance in this section used financial data from the Securities and Exchange Commission (SEC)-BusinessWorld Annual Survey of Top 1.9 7.5 8. only to be unsettled by the crisis of 1997.8 8.2 8. The Philippines substantially lagged behind other countries from 1990 to 1995 (Table 3. of 9.8 4.3 9. With economic reforms introduced in the 1980s and 1990s.7 (13. 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.7 5.3 7. Key Indicators of Developing Asian and Pacific Countries 2000.0 8.3 8.3 9.9 (1. .000 corporations.2) 0.5) 3. however.2. net sales of the top 1.9 5.7 Malaysia 9.1 4.1 8. Its growth rate began to catch up with others in 1996.6 7.8 5.0 (6.158 Corporate Governance and Finance in East Asia. competition from liberalized imports had somewhat reduced oligopolistic tendencies and concentration in many industries. only nonfinancial companies were used.2 7.5) 5.1 5. II market.2) 4.7) (10.7) 10.8 percent growth in fixed 2 The SEC-BusinessWorld Annual Survey of the Top 1. Rep.5 8.3 2.1 5.2).2 (0.0 7.8 10.0 8.2 Korea.8 5.4 Philippines 3.9 6. Table 3.0 (0.8 8.2 Source: ADB. which was taken as a representation of the Philippine corporate sector.1 GDP Growth of Southeast Asian Countries. Vol.5 9.2 9. This rate of growth was sustained by a comparable 18.6) 0. 1990-1999 (percent) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Indonesia 9.7 8.2 Thailand 11.000 Philippine companies grew 17.2 7.000 Corporations covers financial and nonfinancial companies. In this section.1). 3.5 percent per year (Table 3.
209.512.2 136.2 707.7 218.5 192.3 862.6 896 0.2 378.2 2.1 714.1 33.893.0 148.1 181 11.2 1.697.5 193.6 290.9 2.2 338.7 443.317.8 411.1 95.191.3 68 7.7 903 0.3 121 12.000 Companies.9 629.2 2.6 5.8 5.160.9 1.8 26.5 64.1 72.5 4.Table 3.9 896 2.5 72 7. of Companies Sales per Company (P billion) 899 0.0 1.4 602.2 900.7 1.3 898 1.6 109 12. turnover = net sales/total assets.2 Compound Growth (%) 17.6 144. 1988-1997 1989 519.7 20.2 Average 146 12.3 941.7 73 6.1 66 12. net profit margin = net income/net sales.3 60 10.3 382. Source: SEC-BusinessWorld Annual Survey of Top 1.9 96.4 411.7 28.8 6.781.6 35.8 902 1.1 4.1 5.647.4 776.5 14.1 1.131.8 618.332. .0 1.1 615.9 78 6.1 51.6 75 6.3 107 13.4 188.177.4 555.5 508.4 Financial Ratios (%) Leverage ROE ROA Turnover Net Profit Margin 222 14.8 22.9 617.2 Indicators 1988 Growth Indicators (P billion) Net Sales Net Income Fixed Assets Total Assets Total Liabilities Stockholders’ Equity Retained Earnings 464.9 3.6 900 1.6 1990 1991 1992 1993 1994 1995 1996 1997 1.5 Leverage = total liabilities/stockholders’ equity.9 952.4 260.394.5 119 12.1 881.1 6.5 1.000 Corporations in the Philippines.1 1.2 Growth and Financial Performance of the Top 1.5 51 4.3 46. return on assets (ROA) = net income/total assets.4 8.2 27.5 1.1 54 11.5 446.6 1.6 954.6 102 16.6 426.8 77 7.225. return on equity (ROE) = net income/ stockholders’ equity.341.5 570.9 898 1.7 1.9 149 6.4 898 1.1 468.4 1.9 480.8 4.3 306.2 4.4 3.1 Other Indicators No.0 900 1.8 741.1 197 14.7 238.5 887 0.561.6 149 12.4 861.1 73 5.978.123.5 1.4 63.6 18.
697 1.172 2. 1988-1997 Top 1. Asset growth was funded by debt that grew at an average of 20.4 24.000 Corporations in the Philippines. various years. Assuming Table 3. This is high compared with developed countries but compares favorably with other Asian countries. Sources: ADB.352 1. indicating that the corporate sector’s exposure to foreign currency-denominated loans was not as significant as in other countries. The debt-toequity ratio ranged from 222 percent in 1988 to 102 percent in 1994.474 1.178 1. for the 10-year period.000 companies averaged 7. leverage increased from 109 percent in 1996 to 149 percent in 1997.979 17.5 Value-added is assumed to be 30 percent of net sales. Net income consistently increased from 1988 to 1996 and declined only in the crisis year 1997.8 19. These rates of return are high compared with other Asian countries. but the extent of the increase was not as dramatic as in other Asian countries.9 percent for the period.3).5 17. Return on equity (ROE) and return on assets (ROA) averaged 12.906 2.9 21. and the SEC-BusinessWorld Annual Survey of Top 1.000 Companies Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average Growth (%) a GDP (P billion) 799 925 1.5 Ratio of Estimated Value Addeda to GDP (%) 17. The growth rates of corporate sales for the period 1988-1997 exceeded those of the country’s GDP for the same period (Table 3.9 23.394 1. respectively. Vol.1 19.6 percent and 5.693 1.1 Net Sales (P billion) 465 519 630 741 862 954 1.7 percent. The data suggest no evidence of excessive borrowing in the run-up to the crisis in 1997. .248 1.4 20.5 16. Further.2 percent. Net profit margins for the top 1.077 1. Key Indicators of Developing Asian and Pacific Countries 1999. Total assets grew at an average annual rate of 22.3 The Corporate Sector and Gross Domestic Product.8 17.160 Corporate Governance and Finance in East Asia. and by equity that grew at a higher average annual rate of 26.8 percent per year.427 13.3 percent. II assets.
0 5. corporate control structure. Performance by Ownership Type The Philippine corporate sector can be categorized into four groups based on ownership: (i) publicly listed. (ii) foreign-owned.4 Total Liabilities 26.3 9.4). these figures suggest a significant and increasing contribution of the corporate sector to GDP. (iii) Government-owned.8 Growth Indicators (Compound Annual Growth Net Sales 20.4 190 5. and industry reveals further structural characteristics of the growth and financial performance of the corporate sector.3 11.8 No.0 4.3 146 6.7 22.8 3.3 42.5 23 4.5 Source: SEC-BusinessWorld Annual Survey of the Top 1.4 Growth and Financial Performance of the Corporate Sector by Ownership Type. A study of company performance by ownership type.9 17.8 ForeignOwned 21.9 196 1.3 27.0 Net Income 19.1 ROA 8. The foreign-owned companies were the Table 3. %) 17.9 22.3 22. and (iv) privately owned.4 Fixed Assets 19.2 103 5.7 2. Averaging 42.8 606 0.2 9.0 142 22. of Companies 73 Sales per Company (P billion) 2.0 31.0 28. various years.1 Financial Ratios (%) Leverage 89 ROE 15.8 22.3 22.8 2.8 14. 1988-1997 Indicators Publicly Listed Privately Owned Rate.9 26.5 GovernmentOwned 4.9 158 13.5 27. .1 12.000 Corporations in the Philippines. size.5 Other Indicators Share of Sales (%) 17. The premise is that these variables have a direct bearing on corporate performance and growth.6 Total Assets 29.8 percent of the corporate sector’s total sales between 1988 and 1997.0 Turnover 53 Net Profit Margin 15.5 Retained Earnings 30.4 Stockholders’ Equity 32. privately owned companies constituted the largest group (Table 3.0 5.1 22 10.4 28.Chapter 3: Philippines 161 a constant ratio of value added to sales.
The privately-owned companies had a high average leverage ratio of 158 percent. these companies were comparatively large. These were mostly large public utilities. Publicly listed companies had a minor though steadily increasing share in total sales. with an average ROE of 22.162 Corporate Governance and Finance in East Asia. and the second lowest asset turnover. although small in number. Publicly listed companies had the lowest leverage at 89 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 asset base is large. they generated the highest return on investments.1 billion per company in 1997. reflecting the significant presence of holding companies as the gross revenues of holding companies flow through to operating income. The privately-owned companies were only about one third of the average size of per company sales of the publicly listed companies. a level high by Western standards but at par with those of other Asian countries. . With an average leverage ratio of 142 percent. II second largest at about 27. but lower than those of foreignowned and publicly listed companies.2 percent and ROA of 9.5 percent average growth rate of the entire corporate sector.8 percent for foreign-owned companies and 20 percent for publicly listed companies during 1988-1997. compared with P2. or 38 percent. exceeding the 17. selling an average of P4. However.9 percent. the second best ROE and ROA. Privately-owned and Government-owned companies grew at slower rates.000 companies in 1997.3 percent. and low return on investment is the norm. and government-subsidized agencies such as the National Food Authority and Local Water Utilities Administration.000 list. the highest net profit margin of 15. But by being most efficient in employing assets. Governmentowned companies in the top 1. 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. The compound annual sales growth rate was 21. Their ROA and ROE were both more than twice as high as those of government-owned companies. registered the largest per company sales at about P9 billion in 1997. while there were few of them. followed by publicly listed ones. were among the top 1. foreign-owned companies borrowed more than publicly listed ones. Only 84 of the 221 public companies listed on the Philippine Stock Exchange (PSE). meaning that the remaining 62 percent were relatively small in sales and assets. Vol.75 billion per company for foreign-owned companies. Bases Conversion Development Authority.5 percent.
2 Net Income 21.7 Total Assets 32. various years.8 Growth Indicators (Compound Annual Growth Rate.3 percent for the conglomerates. and achieved higher returns on invested assets than independent companies (Table 3.6 26.3 No.2 Fixed Assets 25.1 124 5.1 Retained Earnings 32.5). compared with 32. %) Net Sales 20.5 Growth and Financial Performance of the Corporate Sector by Control Structure. medium.6 715 0. The independent companies contributed about 56 percent of corporate sales on average during the period 1988-1997.3 Other Indicators Share in Sales (%) 32. 1988-1997 Indicators Group Member Independent 18.000 Corporations in the Philippines.8 6. of Company 159 Sales per Company (P billion) 2.0 22.0 55. depending on assets and sales. grew faster.0 Turnover 67 Net Profit Margin 12.Chapter 3: Philippines 163 Performance by Control Structure By control structure.2 23.3 Total Liabilities 30.4 24. and small companies.1 Source: SEC-BusinessWorld Annual Survey of Top 1. Performance by Firm Size By firm size.3 Financial Ratios (%) Leverage 98 ROE 15. Table 3.7 Stockholders’ Equity 34.0 25. had a lower leverage ratio.7 2. a company can be a member of a conglomerate or independent. But the conglomerates were larger measured in sales per company. Sales and resources of the . the corporate sector is divided into large.0 166 15.8 ROA 8.
000 list.6 36.1 ROA 5. However. are defined as the largest 100 companies in the top 1.000 list.5 128 10.7 Net Income 1.3 Turnover 65 Net Profit Margin 8.5 25.9 Financial Ratios (%) Leverage 158 ROE 13.1 81 9. Vol. which.5 Total Assets 18.0 7. indicating that they deployed resources more efficiently than large and small companies.000 Corporations in the Philippines. 1988-1997 Indicators Large Medium 19.6 Small 19.0 730 0. of Companies 79 Sales per Company (P billion) 7.5 Growth Indicators (Compound Annual Growth Rate. while small companies.3 Fixed Assets 15.0 32. Medium-sized companies.1 No.3 Source: SEC-BusinessWorld Annual Survey of Top 1.1 percent of the total sales of the corporate sector. averaged only P920 million in per company sales during the same year. Medium-sized companies also performed better in terms of ROE. although they comprised only 8. for this study.6).6 31. defined in this study as the next 200 largest companies in the top 1. averaged a far less P3 billion in per company sales. .4 Total Liabilities 18.9 32.1 25. various years. Table 3.7 44.9 Retained Earnings 13.9 89 1.4 28.0 156 16.5 12. Large companies accounted for 56.164 Corporate Governance and Finance in East Asia.2 Stockholders’ Equity 18. II Philippine corporate sector are highly concentrated among the large companies.8 percent of the total number of companies in the list (Table 3.2 Other Indicators Share in Sales (%) 56.6 47.1 4.6 Growth and Financial Performance of the Corporate Sector by Firm Size.4 billion in 1997. Sales per company in this group averaged P13.6 49. sales of mediumsized companies grew faster than large companies. referring to the remaining companies in the list. %) Net Sales 15.9 26.2 25.5 73 6.2 29. averaging 16 percent.
ROE dropped from 10.8 percent in 1997.. The real estate and property sector also suffered significantly in sales.7 billion and P35. manufacturing. but suffered its largest decline in net profits in 1997. unlike their counterparts in other Asian countries. and construction. profits. assets. i.7. and equity up to 1996. from 14. Poor returns appear to have been caused by the low profit margin at 6.5 percent for medium-sized companies and 8. at 156 percent. Large. specifically those industries least and most affected by the financial crisis. showed the lowest ROE. at -12. Medium-sized companies apparently enjoyed efficiencies associated with economies of scale and made more productive use of their assets. For small companies. Sales revenue and net income declined from P76. as indicated by the negative annual growth. with their ROE dropping to 3.8 billion in . at 128 percent for the period. averaging 10. and profitability in 1997 when the crisis started.2 billion in 1997 for this sector.4 percent in 1997 from 11. but lower than that of construction. are shown in Table 3. The Asian financial crisis affected large companies most severely. reflecting to some extent a “bubble” phenomena in the former two sectors.6 percent. of net income.1 billion in 1996 to P4. Leverage was the highest for large companies. although the largest in number. and utilities and services sectors.and medium-sized companies did not substantially increase their leverage in years running up to the crisis in 1997. Performance by Industry This study also looked at corporate performance by industry.8 percent. The growth and financial performance of selected industries.Chapter 3: Philippines 165 Small companies. compared with 9.2 percent for large ones. Net income declined from P54. real estate. utilities. especially during the period 1994-1996.e.8 the previous year. ROE dropped to 7. and assets was much higher for the real estate and property. net income. The sector showed consistent growth in sales.1 percent. and utilities and services sectors. and the construction sectors than for the manufacturing. net income. 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. But small companies’ leverage was significantly lower. The leverage ratio of the manufacturing sector was higher than that of the real estate and property sector. Growth of sales.7 percent in 1997 for medium-sized companies. at 158 percent on average during 1988-1997.7 percent in 1996 to 8. Mediumsized companies’ leverage level was slightly lower.7 percent a year earlier.
1 24 42.3 Retained Earnings 17.0 31 0. With a modest increase in total liabilities and leverage level of less than 100 percent in 1997.3 Fixed Assets 20. .8 Stockholders’ Equity 21.7 Net Income (12.4 16.7 83 2.000 companies’ total sales on average during 19881997.2 37. it does not appear to have been excessively exposed to foreign currency-denominated loans. various years.9 5.3 20.4 percent.5 Other Indicators Share in Sales (%) 82.9 23.7 28. %) Net Sales 16. Its knock-on effect on the economy was small as it accounted for less than 3 percent of the top 1. the sector’s ROE dropped from 15. 1996 to P56.6 69 16.7 ROA 5.9 17.9 2.2 28 0.9 billion and P24.3 5. But the impact of the Asian crisis on the real estate and property sector was much smaller than that on the manufacturing sector.9 2.1 2.0 Turnover 112 24 Net Profit Margin 5. Vol.4 Source: SEC-BusinessWorld Annual Survey of Top 1.7 Indicators Manufacturing Construction 27.7 10.7 percent to 10.2 12.6 Growth Indicators (Compound Annual Growth Rate.166 Corporate Governance and Finance in East Asia.8) 17.4 3.8 48.7 19.8 41. 1988-1997 Utilities Real Estate and and Services Property 39. and was also much more limited compared with the property sectors in other Asian countries. The sector’s buildup in equity during the stock market boom of 1994-1996 may have cushioned the impact of the crisis.5 12.7 192 9.4 19.0 25.6 No.7 Growth and Financial Performance of the Corporate Sector by Industry. II Table 3.7 billion in 1997.1 10.6 Total Liabilities 18.7 52. As a result.3 55. respectively.4 Total Assets 19.000 Corporations in the Philippines.0 23.2 8.6 Financial Ratios (%) Leverage 142 181 ROE 13.0 21.2 45. of Company 454 17 Sales per Company (P billion) 1.
. One month after registration.Chapter 3: Philippines 167 The utilities sector had the second highest leverage during 19881997 at 181 percent on average. For publicly listed companies. (v) number of directors (not less than five nor more than 15). Overall. (ii) purpose of the corporation. and amount of authorized capital stock. (vii) number. (iv) term of existence. which regulates banks and nonbank financial institutions except insurance companies. and restrictions. the leverage of all four industries was low. administrative regulations. and residences of original subscribers. It provides the basic constitutional structure for the organization.3 Legal and Regulatory Framework The Corporation Code of 1980 is the main law governing the corporate sector. nationalities. which was based on American corporate law. and residences of incorporators and directors. contains some provisions affecting corporations’ dealings with banks.2. which is also the organic law governing the operations of SEC. 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 General Banking Law. unlike in neighboring countries hit by the Asian crisis. privileges. operation.3 which serve as the company’s declaration that the minimum percentage of authorized capital required by law has been subscribed and paid-up. and dissolution of corporations. and the Insolvency Law. and (viii) names. and recognized rules on corporate practices. 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. Under the Code. reaching up to 313 percent in 1997. The currency devaluation bloated the foreign currency-denominated loans of these companies. the Corporation Code of 1980 is a compilation of important juridical rulings. It specifies the minimum information to be indicated in the articles of incorporation. the Code requires a corporation 3 A company’s articles of incorporation should include: (i) corporate name. par value. the Revised Securities Act (RSA) and PSE’s public listing requirements also apply. (vi) names. Two other pertinent laws are Presidential Decree (PD) 902-A. 3. and amount subscribed and paid by each. Corporation Code of 1980 Supplanting the old Corporation Law of 1906. nationalities. (iii) principal office. the ownership of Filipino citizens in the corporation is not less than the legally required percentage of capital stock.
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. (iii) qualifications. and should not impair vested rights. Securities and Exchange Commission: PD 902-A SEC is the government agency responsible for implementation of the Corporation Code. A majority of the outstanding shares of shareholders must vote to authorize amendments to the bylaws. and control (adjudicative) of all corporations. In 1976. duties. place. and manner of calling and conducting regular or special meetings of the directors and shareholders. and forms of proxies and manner of voting them. To be valid. and (vii) manner of issuing certificates in the case of stock corporations. 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. It implements rules and regulations that protect minority shareholders from possible fraud and misbehavior by controlling shareholders. between the shareholders and the corporation. (iv) time for holding annual election of directors and manner of giving the election notice. II to adopt a code of bylaws or rules for its internal governance. among shareholders. the bylaws must be consistent with the law. (v) manner of election or appointment and term of office of all officers other than directors. must be general. (ii) required quorum in shareholders’ meetings. (iii) controversies in the election or appointments of directors and officers of corporations. (vi) penalties for violation of the bylaws. 4 Some of the items that a corporation may provide in its bylaws are the following: (i) time.168 Corporate Governance and Finance in East Asia. (ii) controversies arising out of intra-corporate relations. officers. uniform. Its mandate is to supervise corporations in order to encourage investments and protect investors. In addition. directors. and employees. and reasonable. manner of voting. . supervision (regulatory). However. 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. Vol. the corporation’s articles of incorporation.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. shareholders may delegate this power to the board of directors by a two-thirds vote of outstanding capital stock. and public policy. or officers. and compensation of directors.
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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.
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
holding only an average of 2. There are advantages to establishing pure holding companies. Who are the top one. In 76 companies. 66 percent (signifying strategic control). Parent companies usually spin off operating units into new companies that they continue to control as affiliates. a single shareholder held two-thirds majority control.174 Corporate Governance and Finance in East Asia.1 percent of publicly listed companies in the Philippines in 1997. or almost 75 percent of the total. or 3 percent of the total. including pure holding companies. Vol. the top 20 shareholders collectively owned a majority of a company’s shares. large and family-based shareholders pool the family’s ownership over many . Table 3. The shares of publicly listed companies are thinly traded and illiquid. or 80 percent (only nominally publicly listed) of outstanding shares. controlling an average of 52. Through these.2 percent of outstanding shares of publicly listed companies. and 20 shareholders? In Table 3. a single owner owned more than 80 percent of outstanding shares. or 14 percent of the total. and share prices are sensitive to movements of foreign funds. or 20 shareholders owned more than 50 percent (signifying operating control). the top five shareholders owned more than 50 percent of the voting shares. or 51 percent of the total. The limited volume of shares issued to the public is one of the causes of the underdevelopment of the Philippine stock market. five. the top five controlling shareholders were classified into eight groups. With such high levels of ownership concentration. the top five shareholders held more than two-thirds majority control of a company. In 116 companies. Nonfinancial corporations with controlling shareholdings are likely to be holding companies. Composition of Ownership of Publicly Listed Companies Another important issue concerning corporate ownership is the composition of the controlling shareholders. five. nonfinancial corporations held majority control. In four of 11 nonfinancial sectors.9 shows that in 44 companies. 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 largest group is nonfinancial corporations. or 78 percent of the total. a single shareholder held operating control of a company. or about 30 percent of the total. In 21 companies. Individuals did not constitute a significant shareholder group among the top five shareholders. which are mostly privately owned and controlled by family-based shareholder blocs. In 111 companies.10. II analysis of the number of companies in which the top one. In four companies.
Distribution. a Data for top 20 shareholders were not available for five holding companies. 10 manufacturing companies. and two companies in the property sector. 1997 % of Firms with Top Shareholders Controlling more than 50% of Shares Top 1 30 40 50 20 31 — 14 24 30 90 80 86 72 73 50 57 72 74 100 87 93 36 82 100 100 80 78 20 13 43 8 14 — — 8 14 70 60 57 48 49 50 14 52 51 Top 5 Top 20a Top 1 Top 5 Top 20a 90 80 86 36 76 100 71 76 72 % of Firms with Top Shareholders Controlling more than 66% of Shares % of Firms with Top Shareholders Controlling more than 80% of Shares Top 1 — 13 7 — 2 — — — 3 Top 5 40 33 50 28 27 50 — 28 30 Top 20a 60 67 64 20 47 50 43 36 45 Sector Communication Construction Food. Beverage. and Tobacco Manufacturing.9 Ownership Concentration at Critical Levels of Control Over Publicly Listed Companies. . Source: PSE databank.Table 3. and Trading Holding Power Transportation Property Total — = not available.
2 5.7 3.9 0.0 0.0 10.0 0.2 0.1 0.8 0.3 37.2 59.3 0.0 1.5 4. Distribution.4 1.6 9.3 1.0 1. and Trading Hotel. 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.5 0.8 66.4 8.0 0.6 12. and Tobacco Holding Companies Manufacturing.6 0.0 2. .1 7.6 5.1 a Weighted by market capitalization.0 0.6 18.7 0.0 0.2 3.2 3.2 0.8 0. Source: PSE Databank.0 0. Recreation.0 1.6 33.3 0.0 7.0 0.6 2.0 0.1 9.9 36.7 3.3 0. and Other Services Property Mining Oil Average Shareholdinga 33.2 0.0 1.5 26.5 13.3 0.1 8. Beverage.6 1.4 19.6 0.5 0.0 1.0 0.7 0.5 2.0 5.7 67.3 0.0 0.8 0.1 0.3 26.4 5.8 21.5 53.1 1.6 0.2 0.0 0.0 4.6 0.Table 3.7 0.3 5.3 2.0 1.0 45.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.5 12.6 0.7 0.2 0.2 10.3 5.0 5.0 5.6 0.0 0.0 5.6 2.8 11.9 52.2 3.0 0.2 3.1 5.9 0.3 12.0 1.4 0.0 2.1 6.3 1.4 29.7 1.0 0.9 6.4 2.7 0.2 1.6 0.0 1.5 4.0 0.7 0.
Because of limited ownership by institutional investors. Holding companies were themselves 66 percent owned by other nonfinancial corporations. The financial institutions among the top five shareholders of nonfinancial corporations are investment trust funds (with 4. accounting for P258. These include Philippine Long Distance Telephone Company (PLDT) in telecommunications.6 percent of market capitalization in 1997.1 percent). . Investment trust funds were the most important institutional investors. 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. securities brokers (1. The Philippine capital market did not have an active analyst community comparable to those in more developed capital markets. Petron and MERALCO in power and energy.1 percent). These are mainly the Social Security System (SSS) and the Government Service Insurance System (GSIS). Funds of SSS and GSIS consist mainly of compulsory contributions from members of the country’s private sector and government workforce.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. Holding companies as a sector had the largest market capitalization in PSE in 1997. there was no real market for investment information. respectively. with an average of only 7. while still allowing the public to own minority shares. The investment funds’ presence in these sectors ranged from 8. financial institutions did not have a significant ownership in nonfinancial corporations. 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.2 percent in 1997. These institutions keep a stock portfolio mostly in shares of a few companies with large capitalization and high liquidity in select industries.Chapter 3: Philippines 177 companies and share in the risks and profits of the group.7 percent of market capitalization of the nonfinancial publicly listed companies.7 percent of shareholdings). commercial banks (1. The 7. They can also better manage their income taxes because income from affiliated companies passes through a holding company.5 to 12. Such advantages have contributed to the popularity of holding companies among publicly listed companies. As a group.6 billion or 26. This complex layering of ownership masks the identity of individuals or families that actually own and control operating companies. and San Miguel Corporation (SMC) in food and beverages.3 percent).
using data on the Philippines’ top 1. A common feature of corporate ownership of a business group is the centrality of a commercial bank. 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. suggesting that most publicly listed companies are parts of business groups. of the financial resources in the country. This could further increase the concentration of ownership and expand the scope of own-group lending by these larger banks.11). Banks that are members of business groups have an advantage in raising funds from the internal capital market of the group. Family-based groups have larger companies since their total sales were about 33. 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.000 Corporations in the Philippines. suggesting that business groups are common in all major markets. including SBL and DOSRI rules. . Corporate financing depends on intermediation by banks. so far limiting their involvement to selected products.4 percent of the top 1. The Central Bank deregulated interest rates and foreign exchange.000 companies. Commercial banks hold the largest share. The process identified a total of 238 companies belonging to 39 business groups from the SEC-BusinessWorld Annual Survey of the Top 1. and increased the capital requirements for all types of banks. but they comprised only 23. To understand the ownership and governance characteristics of family-owned business groups. All major industries were represented. However.7 6 7 The study used publicly available shareholder information and published reports. the Central Bank’s reforms are probably changing the conduct but not necessarily the structure of the banking system.178 Corporate Governance and Finance in East Asia. including 16 commercial banks. identified the companies belonging to each of these groups. For this reason. liberalized the regulations on entry of foreign bank branches and foreign ownership of local banks. Vol. Some 20 financial institutions were affiliated with these groups.8 percent of total companies in number. about three fourths. many companies in family-owned groups are not publicly listed. remain in force to control excessive lending of banks to insiders. More than three fourths of the respondents are either a parent or subsidiary (about 70 percent of these are domestic nonfinancial companies). a nonfinancial company that owns a commercial bank has better access to loans at favorable rates and terms. the study put together a list of prominent business groups. Large shareholders and their families own these banks directly or through their controlled companies. Prudential regulations. Still. Foreign banks have a growing presence but have not necessarily increased the supply of credit to the corporate sector.6 The total sales of these groups in 1997 were estimated at P806 billion (Table 3. and tracked the financial performance of each company from 1992 to 1997. This is significant considering that there were only 31 local commercial banks in the country in 1997.000 corporations’ sales.
Significantly. and more than 20 percent for the Lopez group and Henry Sy group. 25 out of the 50 top corporate entities were familybased groups. or an average of about 12 per group. construction. it was manufacturing (36. Also. which was majority-owned by the Henry Sy group. the top 10 family-based business groups had only 119 companies in the top 1. Family-based business groups are most dominant in sectors such as manufacturing. the largest family-based business group was the Ayala Corporation Group. and Henry Sy—as examples. retail merchandising (69. In terms of sales. In terms of number of companies. These corporate entities accounted for 53. for the Gokongwei Group. the two were closely related through their affiliations to business groups.Chapter 3: Philippines 179 Compared with other Asian countries. a substantial proportion of group profits came from its financial subsidiaries. for the Lopez group. as discussed in previous sections. Together.4 percent of the group’s 1997 profits). real estate. ranged according to their sales (Table 3.000 companies. Commercial banks are often affiliated to a particular business group. Foreign-owned companies mainly serve the export markets. broadcasting (49. in most . the three largest entities were family-based groups. and banking. Commercial banking contributed about 40 percent of group profits for the Ayala group and Gokongwei group. the largest was the Eduardo Cojuangco group. an average group in the Philippines has fewer member companies.6 percent of the total sales of the top 1. Gokongwei. namely.8 percent). the principal owner of SMC. In 1997. and for the Henry Sy group. Cojuangco. 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. for each of these groups. To show this.2 percent). It is also noteworthy that.000 corporations in 1997. nonfinancial companies contributed about 36 to 60 percent of total profits for these groups.12).000. and Ayala. including business groups and independent companies. Lopez. with 27 affiliated companies in the top 1. The main constraint may be the availability of family members that could be drawn for top management positions. the study used the four largest business groups—Ayala. with the exception of Banco de Oro. Lopez.1 percent). For the Ayala group. In the meantime. The significance of family-based business groups in the Philippine corporate sector is immediately evident in the 50 largest corporate entities. the biggest private company in the Philippines. the nonfinancial sector was real estate (60.
and tobacco Telecommunications Cement and construction materials Pharmaceutical and distribution 12. and Affiliated Bank of Selected Business Groups.0 26.6 7.1 2. real estate.3 3.5 13. 17.5 44.0 13.6 3. Eduardo Cojuangco Lopez Family Group Ayala Corp. and dairy products Investments.0 Average Sales Per Company (P billion) 6.3 15. telecom.6 3.5 26. 5.4 6. 16.3 2. and mining Management. 6. Real estate.1 4. coconut oil. Flagship Company.6 2. construction.9 2. 8.0 17.8 84. Consunji 4 3 Food and dairy products Construction and mining 10. and car manufacturing Car manufacturing and real estate Food and telecommunications Department store and real estate Airlines. and tourism Credit card 18.2 1.4 48. 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. agriculture. and food Food. power.11 Total and Per Company Sales. food.7 98. 9.5 6. 11.5 46.9 3. and personal care prods Shipping. 15. Sector Orientation.4 . 14. 13. beverages. food.2 16. 3.0 5. and packaging Power distribution and mass communications Real estate.Table 3. 2. 4. of Affiliated Companies Total Sales (P billion) 123.4 10.5 17. 1997 Business Group 19 15 27 12 12 9 4 6 11 4 8 9 5 4 5 6 Major Sector Orientation Estimated No.3 11.5 47.2 1.1 4.5 2. Beverages. 10.5 49. 7. beverages.
22. Ramos Gaisano Family Group Felipe Yap Felipe F.1 805.8 Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. 24.4 5.19.3 7.6 3. mining. 35.2 4.6 2.9 0.8 1.0 5.3 2. distribution.7 0.5 2.9 1. 36. 4 238 1.7 3. 23. 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 8.9 1.7 1.9 0. 25. and various company annual reports.9 7. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C.7 4.0 0. 26. SEC-BusinessWorld Annual Survey of Top 1. 37.1 0. 30. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/ Fil-Estate Group Total Real estate Sources: PSE Databank.9 6.5 8.8 1.4 1.4 3. 32.8 1.9 1.6 0.6 Fast food Beverages and agro-industrial products distribution Cement and wood products Retail merchandising Electronic appliances Real estate Mining Real estate Telecommunication. 33.4 3. 27.8 6. 21.7 0.6 5.1 2.2 6. 31.3 2.2 1. P. 28. and real estate Retail merchandising Ceramics and real estate Department store and real estate Cement and sugar central Real estate and securities trading Bookstore. 20. 38.0 1. .0 2.000 Corporations (1997).7 0. 34. 29. 39.1 1.1 1.
17. 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.11 (continuation) Total and Per Company Sales. 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. 18. 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. 15. Alaska Milk Corporation DM Consunji. 5. Flagship Company. 3. 20. 4. 13. 2. 6. 9. 8. 1. Uytengsu/General Milling Group David M. Eduardo Cojuangco Lopez Family Group Ayala Corp. and Affiliated Bank of Selected Business Groups. Sector Orientation. 10. 7. Jollibee Foods Corporation Pepsi Cola Products Alsons Cement . 21. Inc. 11. 12. 16. Long Distance Telephone Phinma Zuellig Pharmaceutical Metro Pacific William Gothong and Aboitiz Swift Foods/RFM House of Investment Anscor Equitable Card Network Inc. 19.Table 3. 14.
.48 billion. Ramos Gaisano Family Group Felipe Yap Felipe F. SEC-BusinessWorld Annual Survey of Top 1.000 Corporations (1997). Fil-Estate Development Inc. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. 36. Inc.48 billion. 38. 33. 28. 25. 37. unless otherwise indicated. Keppel-Monte Bank Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. P.65 billion to P4. Sources: PSE Databank. F. 39. 29. 22. 34. Kepphil Shipyard Inc. 32. 23. 30. 26. PT&T Corp.East-West Bank International Exchange Bank Ecology Bank (Savings Bank) Dao Heng Bank Orient Bank International Exchange Bank International Exchange Bank Philbanking Corp. a b Size class is measured in terms of sales: Large = greater than P4. 31. Cruz & Co. medium = P1. . small = less than P1. 35. 27. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/Fil-Estate Group Medium Medium Small Medium Medium Small Small Small Small Medium Small Medium Small Small Small Small Small Small Rustans Solid Group Filinvest Philex Mining Megaworld Properties Jaka Investment Corporation Uniwide Corporation Guoco Ceramics Ever Gotesco Republic Cement PhilRealty National Bookstore Gaisano Department Store Lepanto Consolidated Mining F. 24.65 billion. and various company annual reports. Refers to commercial banks.
8. 23. 20. 24. food. 14. 5. coconut oil.).3 15. 18.12 Control Structure of the Top 50 Corporate Entities.1 17.6 26.6 18.5 77. Inc.8 53.2 Business Group Business Group Business Group Government.8 84.5 46. Petron Corporation Pilipinas Shell Petroleum Corporation George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Caltex (Philippines) Inc. and packaging Power distribution.5 15. 2.).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. beverages. First Pacific/Metro Pacific Group 21. 16. car manufacturing. Philippine National Bank Mercury Drug Corp.2 16.2 49. 19.Table 3. 10. 3. power. Texas Instruments (Phils.4 48. bank.0 37. of the Phils. food. 12. 9.5 47.5 26.5 44. 15.0 38. beverages. and telecommunications Department store and banking Airlines.7 98. Fujitsu Computer Products Corp.0 24. telecommunication. 11. Inc. 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. 7. and personal care products Shipping. Del Rosario/PHINMA Zuellig Group Toshiba Information Equipment (Phils. and mining Gold and other precious metal refining . and real estate Banking. 6. Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Philippine Associated Smelting and Refining Corp. 1997 Sales (P billion) Control Structure Major Industrial Orientation 123. 17. Beverages. and car manufacturing Power Refined petroleum products Refined petroleum products Banking. food. 13. agriculture. Eduardo Cojuangco Lopez Family Group Ayala Corporation Group National Power Corp. 4.5 17. and bank Real estate.4 19.1 60. and dairy products Investments.8 22. mass communications. 22. construction. and food Food. banking.
5 8. corn (unmilled).8 9.5 8.4 8.1 9. . 37.6 9. 36. 34. 14.6 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. including biological products Bank Cement and wood products Retail merchandising Electronic appliances Mining Real estate Sources: SEC-BusinessWorld Annual Survey of Top 1.000 Companies Sales (%) Cigarettes Bank Soap and detergents Management.0 5.. and various company annual reports. EAC Distributors Inc.0 13. 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. 48. 50. 47. 49.3 8. Jollibee Foods Citibank N.9 6.6 12. 33. Consunji Uniden Philippines Laguna. and tourism Banking Radar equipment and radio remote control apparatus Operation of rolling mills Palay. and apparatus for line telephony and line telegraphy Tobacco products wholesaling Cigarettes Radar equipment.8 6.2 7. 44.7 10. 42. 32. 26. 40. Inc. radio and remote control apparatus Fast food Bank Beverages and distribution of agro-industrial products Drugs and medicines. Inc.9 14. 45. 31. 30.0 12. Corp.25.3 13.8 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. Inc.5 10.000 Corporations (1997). 28. Amusement and Gaming Corporation Mitsubishi Motors Phils. National Steel Corporation National Food Authority Phil. and other grains wholesaling Other amusement and recreational activities Motor vehicles Food and dairy products Construction and mining Television and radio transmitters. W.0 11.A.7 10.9 7. 27. real estate. 43. 9.9 7. Uytengsu/General Milling Group David M.4 10. 39. Philip Morris Philippines. PSE Databank.7 13. 46. Philips Semiconductors Phils. 41. 35.290 53. 29.6 1.
II publicly listed commercial banks affiliated to these groups. investments of corporate funds in other companies or purposes. However. Shareholders limit the broad power of the board by ratifying their decisions on critical corporate affairs. This section reviews practices of corporate management and shareholder control in Philippine publicly listed companies. The Corporation Code holds members of the board of directors liable. . sale or disposition of a substantial portion of corporate assets. accounting and auditing.186 Corporate Governance and Finance in East Asia. approval of management contracts. corporate mergers or consolidations. 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. removal of directors. 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. the board of directors plays a crucial role in corporate governance. business groups had only minority ownership. determination of compensation to board members. such as amendments of the articles of incorporation. appointment and compensation of senior executives. 3. They are likewise liable if they pursue financial interests that conflict with their duty as directors. Of course.2 Corporate Management and Shareholder Control The main mechanisms by which shareholders control corporate management are the board of directors. voluntary dissolution. to the corporation and its shareholders for damages caused if they agree to unlawful corporate acts. and declaration of cash dividends. and financial disclosure. amendments in the bylaws. Vol. issuance of stocks. although public investors held a majority of shares. A total of 44 companies responded to the survey (out of about 221 financial and nonfinancial listed companies). these were dispersed shareholdings.8 The Board of Directors As the representative of shareholders in a company.3. The Philippine Corporation Code mandates the board of directors to exercise its control over a corporation. Actual control of the banks was still held by the groups. jointly and individually. issuance of corporate bonds. The review is based on an ADB survey of listed companies in the Philippines conducted in 1999 for this study. shareholder voting in general meetings and legal protection of their rights.
But half of respondents indicated that they also had board directors directly nominated by controlling shareholders or management.Chapter 3: Philippines 187 actual practices of board functions and the role of shareholders may diverge somewhat from the legal framework. a typical chairperson owned 3 to 5 percent of outstanding shares of a company on average. The majority of respondents indicated that board directors and chairpersons were elected mainly on the basis of either relationship with major shareholders (31.6 for board chairpersons and 7. Making day-to-day management decisions was not regarded as an important board responsibility. in a descending order. appointed by the Government. ensuring that a company follows legal and regulatory requirements. The ADB survey results show that a chairperson is compensated either by a fixed fee (52 percent of respondents). Financial compensation is another means by which shareholders can motivate boards and board members to manage companies in their interests. . The longest was 27 years for board chairpersons and 14 years for board directors. a fixed fee plus performance-related bonuses (30 percent). The ADB survey shows that the number of board directors ranged from six to nine among the responding companies. and determining remuneration for board directors and senior management.5 for board members. The average stipulated term of office of the chairperson and members of the board for most responding companies was one year.9 percent). This can partly be explained by the fact that many family-based large shareholders control companies through holding companies in which they have majority ownership. or representatives of creditors. Such a short tenure may to some extent suggest that large shareholders want to keep their board members under close control. the average number of years of holding office was 6. More than half of respondents indicated that board directors were elected during the shareholder general meetings. According to the ADB survey. But professional expertise is also an important criterion (28. or a per diem for meetings (18 percent). with a maximum of 36 percent. Board chairpersons in a substantial number of responding companies did not own significant amounts of shares in their personal capacities. In a few cases. appointing senior management. or the Government without approval by shareholder general meetings. In practice.7 percent). or percentages of shareholdings (28.7 percent). Respondents of the ADB survey ranked the following as the most important responsibilities of the board: making strategic decisions. protecting shareholder interests. board directors were the founder of a company.
The Corporation Code prohibits the removal of any director without cause if that act would deprive minority shareholders of representation in the board. audit. negotiates the audit fees and scope of audits. or management (15 percent). The compensation committee reviews and recommends remuneration plans of key officers and employee stock option plans. Ninetythree percent of the respondents had one or more outside directors. by tenure and compensation. and reviews the findings of external audits. only 35 percent of responding companies have set up board committees. the CEO 9 The three most common board subcommittees are the compensation. large shareholder-dominated companies often view such committees as unnecessary formalities. The audit committee selects external auditors. or amount of shareholding (15 percent). the chairperson of the board was also the chief executive officer (CEO). and nomination committees. the parent company or company bylaws (21 percent). These committees were established only recently. A CEO that was not the chairperson of the board was selected on the basis of professional expertise (42 percent of respondents). relationship with controlling shareholders (35 percent). Senior Executives The Corporation Code does not specify the role and responsibilities of senior executives.9 In practice. This suggests that large shareholders control CEOs by means other than shareholdings. There was no case found in the ADB survey where a minority shareholder invoked such a provision of the Corporation Code. In some companies. The ADB survey shows that in 41 percent of the responding companies. But the independence of these outside directors is often doubtful. Vol. namely. It is also not clear whether the outside directors were elected before or after the financial crisis.188 Corporate Governance and Finance in East Asia. however. 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. When the CEO was not the chairperson. II Compensation for the chairperson was determined either by the board (54 percent of respondents). . About half of the active committees were audit committees and the other half nomination committees. CEOs apparently cannot increase their shareholdings because family-based owners restrict the number of shares available to management. In the ADB survey. The nomination committee searches and reviews candidates for key management positions. Unlike in Western corporate models. Companies may set up special board committees to strengthen due diligence procedures.
or (iv) enters into a merger or consolidation with another corporate entity.e. The average service length of CEOs was 5. including electronic means. Fifth. (iii) invests in another company for a purpose different from that of the corporation. shareholders enjoy a number of rights and protection.. shareholders may exercise appraisal rights. the Corporation Code allows cumulative voting for directors. to help ensure the representation of minority interests in the board. and prohibits the removal. Second. 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. (ii) contracts with companies linked through interlocking directorship. About 60 percent of respondents of the ADB survey considered maximizing shareholder values as the CEO’s most important responsibility. 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. But about 27 percent viewed it to be ensuring steady growth of the company. . i. Companies are not allowed to issue shares with different voting rights. if the CEO’s contract was preterminated. Among others. 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. Third.Chapter 3: Philippines 189 was not related to the chairperson by blood or marriage in all of the cases except one. equal to three years’ pay. The “golden parachute” was apparently not a common feature of CEOs’ compensation packages. 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. Shareholder Rights and Protection Under the Corporation Code. shareholders have preemptive rights to maintain their proportionate ownership of a company under any financing plan that may be undertaken by the company. The majority of responding companies compensated their CEOs by using a fixed salary plus a performance-related bonus.2 years. Fourth. of directors representing minority shareholders. The longest service rendered was 27 years. and (iii) involvement of directors in businesses that compete with the company. Only one respondent indicated that its CEO was entitled to a substantial amount of compensation. first. without cause. They can vote through proxy. (ii) disposes of or mortgages a substantial portion or all of corporate properties and assets.
the Revised Securities Act has strict provisions designed to deter insider trading. Few minority shareholders actually exercised their appraisal rights. because of poor compliance and enforcement as well as some loopholes in corporate laws. it is doubtful whether this legal protection for shareholders will achieve what it intends to in practice. There was only one case. In the case of preemptive rights. An effective market for corporate control may provide some protection for minority shareholders against the expropriation of their interests by the incumbent management. Dissenting minority shareholders did not necessarily have recourse to a third party for an objective appraisal of their shares. Sixth. board members are likely to be under pressure to approve transactions that benefit controlling shareholders to the detriment of minority shareholders. potential buyers are required to make a tender offer to minority shareholders at a price equal to the offer it is making to controlling shareholders. II shareholders are allowed to inspect a company’s stock and transfer books. Consequently. because of the dominance of large controlling shareholders. In cases of derivative suits against directors for wrongdoings or actions against insider trading. there are no requirements for disclosing such transactions to shareholders under the Corporation Code. minority shareholders were often vulnerable to the expropriation of their interests by controlling shareholders and management. In the past. Vol. However. hostile takeovers are not common because in most companies ownership is concentrated . Regardless of the amount of shares held. there were often no real discussions of board proposals or actions.190 Corporate Governance and Finance in East Asia. SEC proceedings were costly and time-consuming. There was little chance that a proposal from minority shareholders could ever get approved. Those who did were usually offered below-market values for their shares. The company was dissolved before indictment. Although transactions involving potential conflict of interest need to be reviewed and approved by the board. in cases of corporate takeovers. where SEC made substantial progress in investigation. the Corporation Code allows a company to waive this in the article of incorporation upon registration or in a subsequent amendment. a shareholder could file a derivative suit against a director to redress a wrongdoing. in the Philippines. But an action by the regular court on a petition by the company’s owners/officers prevented SEC from pursuing the investigation. Being appointees of controlling shareholders. no one has been successfully prosecuted for insider trading. In practice. Last. During annual general meetings where minority shareholders could exercise their rights. that of Interport Resources Corporation.
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. An average of 327 shareholders per company attended the last annual meeting and they represented about 63 percent of total shares.7 43.4 No 0. the successful hostile takeover by First Pacific Group of PLDT.Chapter 3: Philippines 191 in a few controlling shareholders and families. The responding companies had on average 43.900 shareholders per company did not vote during the last annual general meeting. and their activism in the corporate sector.8 30. followed by management and banks.0 48. protection.6 Independence of Auditing The ADB survey revealed that all the responding companies had an independent auditor. Yes 100.8 92. a company that is widely held but has a large shareholder.0 63.8 56.6 30. demonstrates the feasibility of developing a market for corporate control if publicly listed companies were widely held. Nominees held about 45 percent of the outstanding shares.0 36. The ADB survey provides further evidence on shareholder rights. Table 3.4 percent of shareholders but 58 percent of outstanding shares.2 43.13 summarizes rights that the shareholders of the responding companies enjoyed.522 shareholders each. Nevertheless.3 56.2 69. Table 3. representing about 24 percent of outstanding shares. An average of about 4. About 93 percent of the respondents contracted . representing 3.2 7. appointed either by the board or shareholders during the annual general meetings.4 70.0 51. 1999. The brokers or securities companies were the most important proxy voters. About 333 shareholders per company voted by proxy.
as practiced in the Philippines). Nevertheless. Nevertheless. long-term leases. the international accounting standard. vary in their evaluation of some major accounts such as securities and other liquid assets. From publicly listed companies. In two celebrated cases. independent auditors are likely to be quite familiar with the operations and financial aspects of their clients. a hostile takeover case). . a management discussion of the business. the information statement transmitted to every shareholder should contain the audited financial statements. An auditor can choose among three alternative sets of GAAP.e. Because of such long relationships. with the longest being 50 years. the responding companies have been associated with their present auditors for 13 years. On average. Most major international auditing firms operate in the Philippines. revaluation of fixed assets. SEC requires all registered companies to periodically submit reports for the purpose of updating their respective registration statements filed at the agency. the US GAAP). although closely related. intangible assets. a preferred independent auditing firm either reported assets that did not exist (Victorias Milling Corp. and an analysis of financial statements. namely. II their annual audit to an international auditing firm. independent audits do not guarantee the absence of questionable accounting practices. In practice.192 Corporate Governance and Finance in East Asia.. financial reporting standards allow room for interpretation by independent auditors. The Code grants a shareholder the right to inspect business records and minutes of board meetings. there are many cases of poor financial reporting by large companies. imposing penalties on violators. Meanwhile. intra-company receivables and payables. the local standard (i. investments in subsidiaries. These different versions of GAAP. a bankruptcy case) or hid a large amount of liabilities and losses (PLDT. More than 20 percent of the respondents have been dealing with their auditors for 20 years or more. 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. or the accounting standard of a specific developed country (for example. the agency also requires reports on important details about their operations and management. Vol. foreign currency-denominated liabilities.. The accounting profession in the Philippines is considered fairly developed and Manila is a known regional center for accounting expertise. and consolidation policy.
because of the highly concentrated ownership of Philippine corporations. Family-based controlling shareholders use them as vehicles for controlling business groups. When control rights exceed cash flow rights. the authorities. Pure holding companies can be privately owned. which are controlled by large shareholders with public investors in a minority position. However. sometimes did not penalize independent auditors for poorly prepared audited financial statements. Even for widely held public companies. e. from a minority-controlled to a majority-owned subsidiary. accounting for 27 percent of the total stock market capitalization that year. namely SEC and the Philippine Institute of Certified Public Accountants (PICPA). large shareholders can use their control to transfer wealth from a company in a business group where they have low cash flow rights to another where they have high cash flow rights.Chapter 3: Philippines 193 Many small. and financing. “Selective public listing” is a strategy of many business groups for channeling funds from public investors to member companies. marketing. they formed the largest group of corporate entities in the Philippine stock market in 1997. Corporate Control by Controlling Shareholders As in many other Asian countries. arguably.and medium-sized businesses did not have quality financial statements. which are closely held by large shareholders and family members. they also make it easier for controlling shareholders to expropriate interests of minority shareholders. as large shareholders had no need for financial statements to monitor their companies and management that were under their own control. and publicly listed. Such expropriation is due to gaps between control rights and cash flow rights that pyramiding structures of business groups centered on holding companies create. Controlling shareholders usually select member companies that require large . which are usually controlled by holding companies.6 billion. Publicly available financial information was often of low quality. Laws of many Southeast Asian countries allow the establishment of pure holding companies (with the exception of Korea up to 1999).g. controlling shareholders in the Philippines usually exercise their corporate control through the setting up of business groups. They allow risk pooling and can achieve economies of scale in management.. The popularity of holding companies in the Philippine corporate sector is evident: with a market capitalization of P258. Holding companies enable controlling shareholders to collectively own shares of other companies in a business group and to centralize the group’s management.
It is majority-owned by Mermac. Some holding companies are not pure holding companies.194 Corporate Governance and Finance in East Asia. In cases of minority ownership. namely. Ayala Corporation’s majority. II equity investment for public listing.2 percent. a family-owned pure holding company.1). It has a majority control at 71. controlling shareholders of the parent company may eventually increase their shares to a majority position. They are operating companies but at the same time have majority or minority share ownership in other operating companies. These investments can be classified according to the role of the controlling shareholders in the management of the invested company.1 percent of Ayala Land. especially its management. The first three companies are publicly listed while the fourth.. Vol. the parent company plays an active role in management. The stylized features of control structure of business groups in the Philippines can be illustrated by using a leading Philippine family-based conglomerate.and minority-controlled operating companies are also holding companies. active minority or passive minority holdings. at 47. In an active minority-owned operating company. This is most evident when a minority-owned company transacts with other members of the group where the controlling shareholders hold majority control. and customers. Controlling shareholders gain additional leverage in management control over minority-owed companies. controlling shareholders of a parent company hold these shares as “strategic investments” that they could increase or reduce depending on business opportunities. . Depending on the performance of the company. They may have a representative in the board. as an example (Figure 3.4 percent of Bank of the Philippine Islands. with 59 percent of shares. and a passive minority investment at 15 percent in Honda Cars (Philippines). Honda Cars (Philippines). In a passive minority-owned operating 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. an active minority share at 44. Ayala Corporation is a publicly listed pure holding company. Minority-owned companies may also need access to resources of the group. controlling shareholders of the parent company do not participate in management. of Cebu Holdings (a publicly listed government-owned company). Selective public listing combined with use of pure holding companies to own and control member companies lead to various organizational structures of business groups. Ayala Land fully owns Makati Development Corporation and holds a minority stake. minority control at 42. Public investors collectively hold a minority of 41 percent.6 percent of Globe Telecom. Ayala Corporation. financing. Inc. is privately owned.
Inc..1 Corporate Control Structure: The Case of Ayala Corporation Family Members 100% Mermac. (15%) MinorityControlled Operating and Holding Company Bank of the Philippine Islands (42.96%) Privately-Held Pure Holding Company Public Investors (41.6%) <15% Passive MinorityOwned Pure Operating Company Honda Cars Phils. Inc. (47.2%) >50% MajorityControlled Pure Operating Company BPI Family Savings Bank (100%) <50% MinorityControlled Pure Operating Company Note: Data as of 31 December 1998. . (58. Inc.Figure 3.06%) <50% >15% &<50% Active MinorityOwned Pure Operating Company Globe Telecoms (44.44%) >50% MajorityControlled Pure Operating Company Makati Development Corporation (100%) <50% MinorityControlled Pure Operating Company Cebu Holdings.04%) <50% Ayala Corporation >50% Publicly Listed Pure Holding Company >50% MajorityControlled Operating and Holding Company Ayala Land (71.
Lang. Diversification and Efficiency of Investment by East Asian Corporations.64% +37. [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.5% x 14. Simeon Djankov. defined as control by large shareholders of an operating company through minority ownership by several companies. Simeon Djankov.44%] / [58. see the World Bank research papers by Stijn Claessens. Expropriation of Minority Shareholders: Evidence from East Asia. Vol. P.11 The Lopez family’s control rights over MERALCO was 5. MERALCO.10 The Ayala family’s control rights over BPI was 1.14%] / [6. and a minority-controlled holding company. [control right] [control rights via Ayala Corporation] = [cash flow right] [cash flow rights via Ayala Corporation] = [42.2). and Larry H. Rockwell Land. Joseph P. however.3% x 1. Being in the public utilities sector. The Separation of Ownership and Control in East Asian Corporations. Lang: 1999a. companies in the Lopez Group are large and minority-controlled.64%) + (37. P.12 These examples show that even when large shareholder groups are minority shareholders.44%] / [25%] = 1. The situation offers large shareholders tremendous incentive to move resources 10 For details.5%] / [(88. Generally. and First Philippine Industrial Corporation are indirectly held by a majoritycontrolled holding company. and Larry H.7 times 12 .76%)] [39. The control of companies through indirect corporate shareholdings. First Philippine Holdings Corporation. 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.5%] [39. Fan. Who Owns and Controls East Asian Corporations? 11 Ibid.14%] / [1.196 Corporate Governance and Finance in East Asia.7 times its cash flow rights by virtue of its cross-holdings via Benpres and First Holdings.7 times Ibid. they exercise far greater control (two to five times more) than they are entitled to by virtue of their ownership rights.7 times its cash flow rights by virtue of the double layer pyramid structure of the Ayala group.98% x 42. See also Stijn Claessens. Benpres Holdings. and 1999c. 1999b. II Bank of the Philippine Islands owns 100 percent of the BPI-Family Savings Bank. 1998.44%] = [42. is illustrated in the Lopez Group (Figure 3. H.8%] 5.3% x 5. indirect shareholdings do not appear to be a prevalent practice in the Philippine corporate sector.
5% Operating Company MajorityControlled Operating Company Rockwell Land Corporation 24.5% First Philippine Industrial Corporation 50% 50% Note: Data as of 31 December 1998. Inc.2 Corporate Control Structure: The Case of Lopez Group Public Investors Family Members Lopez.7% 62.3% 11. Privately-Held Pure Holding Company 88.5% Minority-Controlled Publicly Listed Pure Holding Company First Philippine Holdings Corporation Benpres Holding Corporation Majority-Controlled Publicly Listed Pure Holding Company Manila Electric Company 1.64% MinorityControlled 14.76% Operating Company MinorityControlled 24.Figure 3. .
Most responding companies had dealt with their commercial bank creditors for more than five years and nonbank creditors for only about two years.198 Corporate Governance and Finance in East Asia. while 80 percent reported that creditors with which they had renegotiated loans were still willing to lend to them. 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. and (ii) how the legal framework protects creditor interests and rights. whether for working capital or capital expenditure. Suspension of Payments of Debts Under PD 902-A. The controlling shareholders could also use the resources of minority-owned subsidiaries to engage in overexpansion and empire building investments. II from their subsidiaries to their majority-owned publicly listed holding company or elsewhere up the pyramid. Sixty-one percent of respondents indicated that creditors usually asked for collateral for all types of loans. SEC could suspend the rights of a creditor to demand payment from a borrower in accordance with the terms of the loan . Some 85 percent of respondents believed that creditors had no influence or only weak influence on corporate management. the data suggest. 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. a publicly listed company dealt with an average of eight banks and six nonbank financial institutions.3.3 The Role of Creditors in Corporate Control This study examines the role of creditors in corporate control by looking at (i) how corporate borrowers perceive the control power of their creditors. However. Only a minority of respondents (18 percent) indicated that they had faced adverse creditor actions such as a collection lawsuit or foreclosure of collateral. 3. Vol. The average company. accessed nonbank creditors for specific purposes but dealt with commercial banks on a long-term basis. Most respondents (81 percent) indicated that they had renegotiated with their creditors on loan repayment when they faced liquidity problems.
a company’s assets are of sufficient value to cover all of its debts. which determines the viability of the rehabilitation plan and appoints a Mancom or a rehabilitation receiver to implement the proposal if approved. bank credit is the main source of corporate financing. This explains why creditors invariably oppose any move by borrowers to file for suspension of payments at SEC. it is not clear whether the corporate borrower’s assets are of sufficient value to cover its liabilities. Publicly listed companies do not represent a cross section of the Philippine corporate . PD 902-A granted SEC blanket powers to intervene and adjudicate claims. the litigation process.Chapter 3: Philippines 199 agreement. wait for 14 years from the time the company petitioned for suspension of payments in 1984. 3. the borrower requests to defer payments for a certain period to enable it to generate the necessary liquidity. The second mode is for suspension of payments with the appointment of a management committee (Mancom) or rehabilitation receiver. under which. Inc. The law on suspension of payments envisions resetting the corporation’s business for a temporary period to prevent its irreversible collapse. Markets for equity and debt instruments are small and there are serious structural problems that discourage large. The first mode is for simple suspension of payments. The corporation continued to be under rehabilitation receivership as of June 1999.4. An impending conflict between the two parties could result in dissipation of assets of the company due to creditors’ action to liquidate the company’s assets they hold as collateral.1 Corporate Financing The Financial Market and Instruments The Philippine financial market has remained underdeveloped compared with other countries in the region. a real estate-based business group.. Consequently. Under this mode. profitable companies from going public. The borrower will propose a rehabilitation plan to SEC. could take an indefinite period. Under such circumstances.4 3. SEC could intervene to avoid asset dissipation. For example. including the rehabilitation of the corporation. SEC and the court required that the creditors of BF Homes. Commercial banks hold about three fourths of the resources of the financial system. In practice. There are no legal or practical limits to the time period of suspension of payments. There are two modes of suspension of payments under PD 902A.
5 billion).. Equity instruments include common stocks. Table 3. The Philippine stock market is not a liquid market. The stock market was depressed up to the early 1990s. this is because. The corporate sector raised a substantial amount of . Equity financing through IPOs was active. Most companies invested only in projects that met hurdle rates as high as 20 to 30 percent and had short payback periods. Korea) ($143 billion). The period 1993-1997 was one of lower inflation and declining lending rates. however. The ratio of market capitalization to GDP over the last 15 years put the development of the Philippine stock market at par with other developing markets in the region (e. and convertible securities. Even in the real estate sector. the collapse of the stock market during the Asian financial crisis suggested that the earlier stock price surge in part reflected the “bubbles” common to other stock markets in the region. the country experienced double-digit inflation. the minimum required to qualify as a public corporation. They invested in only a few large companies whose shares were relatively liquid. From the 1970s up to the early 1990s. especially short-term debt. most listed companies are controlled by their five largest shareholders. Rising stock prices during the Ramos administration reflected to some extent the business optimism. companies expanded only at a moderate pace. is far ahead of the flock. Of the 221 companies listed in the Philippine Stock Exchange in 1997.000 companies. However. Philippine companies were less leveraged. Foreign funds were wary of the Philippine stock market because of its limited liquidity. II sector. and Indonesia ($61.4 billion (or $59 million using the average exchange rate). compared with other economies. and less engaged in risky investments. In part.14 shows that the average volume of daily trading in 1997 stood at P2. The Government financed its chronic fiscal deficits by issuing short-term Treasury bills.g. compared with Malaysia ($186 billion). The crisis affected the Philippine corporate sector. only 84 had sales large enough to be placed in the top 1. Vol. inflation. Interest rates. Foreign portfolio investments also remained small. preferred stocks. As a result. less exposed to foreign debt. was one of the smallest in the region at $47. and fiscal management were among interrelated factors explaining the underdeveloped state of the Philippine financial market.7 billion. Malaysia. Most publicly listed companies issue only up to 20 percent of total shares to the public. the Republic of Korea (henceforth. The market capitalization of the Philippine stock market in August 1997. but not to the same extent as it did in other Asian economies.200 Corporate Governance and Finance in East Asia. Korea and Thailand). while interest rates were at high levels and volatile. about the size of Thailand’s.
1983-1997 Daily Trading Volume (P million) — — — — 129.3 158.248.7 1.088.2 0.5 12.8 1.3 314.Table 3.9 1.3 0.5 1.1 0.3 4.2 0.2 61.8 1.7 207.2 1.8 102.421.373.686.4 9.7 0.0 1.1 5.515.2 ($ million) — — — — 6.474.251.7 391.9 682.1 524.4 728.171.0 0.2 59.7 2.1 0.2 1.4 Ratio of Market Capitalization to GDP 0.351.9 2.9 2.9 114.0 0.9 608.5 Year 369.077.5 72.3 2. P billion) 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 19.8 799.0 161.8 1.2 925. Note: Combined transactions of Makati and Manila Stock Exchanges are not available for the years 1983 to 1986.2 57.0 2.121.3 0.8 0.3 — = not available.692. P billion) Gross Domestic Product (current prices.5 16.5 1.3 Market Capitalization (year end. Source: PSE databank.2 297.9 12.14 Philippine Stock Market Performance.445.3 59.7 41.6 1.6 1.906.4 1.1 88.1 0.386.0 0.545.1 0. .5 26.2 3.5 571.6 261.
Debt instruments include negotiated credits and debt securities. asset-backed credits. leases. sells these commercial papers through brokers. Vol. Only the commercial banks. The underwriter. and the dominance of large commercial banks. tight regulations. by virtue of their large stakes in the financial system.202 Corporate Governance and Finance in East Asia..6 billion. discounting of receivables. Negotiated credits.2 Patterns of Corporate Financing The study looked at retained earnings. The corporate bond market was stunted. moreover. which in most cases is an affiliate of the issuing company. However. which ultimately influences the pricing of commercial paper issues. of which 85 percent was raised from 1993 to the first half of 1997. II equity capital through IPOs during the stock market boom from 1993 to the first half of 1997. Under SEC regulations. lack of competition among financial institutions.4. because business groups often own large commercial banks. the rights issue was a popular way of raising equity capital. However. a strong regulatory system for bank supervision is imperative. are in a position to provide such discipline. which were the principal source of corporate financing in the Philippines. Capital markets cannot provide the market discipline that corporate investors need. by volatile interest rates and the absence of a secondary market. corporate bond issuing was even more limited. new equity. and high transaction costs. 3. and debt as sources of corporate financing by using flow of funds analysis. The measures used in the analysis are: . 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. From 1988 to 1997. Corporate bonds are another type of debt securities. Few companies offer preferred stocks because the Philippine tax system does not allow tax deductibility of dividends on preferred stocks. issuing companies had to undergo a process of review and credit rating by the Credit Information Bureau Inc. which buy commercial papers either for their own account or for their clients. Only a few large companies floated commercial papers because of the limited market. The picture of the financial system that emerges is thus one of limited capital markets. about 127 companies went public with a total value of offerings of about P134. Because existing shareholders wanted to retain their proportionate control over their companies. The largest buyers have been commercial banks. include bank credits. and inventory financing.
It measures a company’s capacity to finance asset growth by internally generated funds.15.8 0.4 0.1 0.8 0.1 0.4 0.5 2. On the other hand. during this period.3 0. Incremental equity financing ratio (IEFR): ratio of changes in shareholders’ equity inclusive of retained earnings to changes in total assets.2 0.4 0.6 0. it is one minus IDFR.4 1. Incremental debt financing ratio (IDFR): ratio of changes in total liabilities to changes in total assets.4 0. Retained earnings were sufficient to finance the entire growth of fixed assets in the corporate sector.9 0.1 0.5 0. . By definition.2 0.5 0. the SFRT was low at Table 3. 1988-1997.5 0. Self-financing ratio of total assets (SFRT): ratio of changes in retained earnings to changes in total assets.9 0.5 0.5 0.0 0. It measures a company’s reliance on borrowings in financing asset growth.5 0. 1989-1997 Financing Indicators SFRF SFRT NEFR IDFR IEFR 1989 1990 1991 1992 1993 1994 1995 1996 1997 1. As shown in Table 3.6 0.4 0.Chapter 3: Philippines 203 (i) (ii) (iii) (iv) (v) Self-financing ratio of fixed assets (SFRF): ratio of changes in retained earnings to changes in fixed assets.4 0.8 0.0 0.9 0.5 0. It measures a company’s capacity to finance growth in fixed assets by internally generated funds.000 Corporations in the Philippines.2 0.1 0.5 0. It measures a company’s capacity to finance asset growth by equity capital.1 0. the average SFRF was high at 109 percent.5 0.2 0.3 0.15 Financing Patterns of the Corporate Sector.3 0.000 Corporations in the Philippines from 1988 to 1997.1 Average 1. New equity financing ratio (NEFR): ratio of changes in stockholders’ equity (excluding retained earnings) to changes in total assets.5 Source: SEC-BusinessWorld Annual Survey of Top 1. All Companies Financial flows data were derived from the SEC-BusinessWorld Annual Survey of Top 1.4 0.2 0.7 0.3 0.6 0.3 0.9 0.3 0.3 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. As a result.3 0. There were significant year-to-year variations. Retained earnings were the least important. suggesting that there was a deterioration of financial performance in the Philippine corporate sector in the years running up to the crisis.5 0. the level of corporate leverage increased. with debt providing 93 percent of the financing requirements.204 Corporate Governance and Finance in East Asia.9 0. except for foreignowned companies that had a negative new equity financing ratio.2 (0. when it financed 45 percent of it.3 0. except in 1991. .7 0.000 Corporations in the Philippines. Total assets grew by 23 percent that year.and foreign-owned. internal funds were not a significant source of financing growth in total assets. Corporate Financing by Ownership Type As shown in Table 3. retained earnings declined and few new equity investments flowed into the corporate sector.5 Foreign-Owned 1. reflecting the capital flight caused by political instability in the early 1990s.2 0. for all three types of companies—publicly listed.16 Corporate Financing Patterns by Ownership Type. In periods of an economic crunch such as in 1989.3 0. Vol. 1988-1997.3 0. II only 19 percent. implying that internal funds were far from sufficient to finance growth in total assets. Source: SEC-BusinessWorld Annual Survey of Top 1.1 a Excludes negative balances. the SFRF was higher.16.0) 0. In all the years. On Table 3. This was mainly caused by the declining contribution from retained earnings.6 0. It can also be observed that the relative importance of stockholders’ equity (including retained earnings and new equity investment) was declining and that of debts increasing in financing the growth of the corporate sector from 1991 to 1997. privately. 1991. and 1997. Companies financed fixed assets from internal sources in hard times.8 0. The corporate sector consistently relied on debt and new equity to finance asset growth throughout the period. 1989-1997 Financing Indicators SFRF SFRTa NEFR IDFRa IEFRa a Publicly Listed 1. In 1997.
0 100.0 9.8 17.8 39.9 24. 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 14.7 2.8 26.7 13.0 8.6 37.4 2.3 51.2 3.3 10. . compared with 47 percent for publicly listed companies and 55 percent for privately-held firms.0 9.4 100.3 12.0 1994 19.0 9.7 2.0 1993 14.4 100.5 12.9 16.4 41.6 43.1 10.2 3.0 10.8 38. The sector built up its short-term debts.2 42. It presents a composition analysis of assets and financing sources for the period 1992-1996.5 9.9 4.9 100.0 38.4 100.4 10.0 12.3 10.8 4.8 0.6 48.2 12.5 0.3 4.1 13.1 49. contributing 90 percent of growth in total assets.4 3.8 46.8 3.7 4. 1988-1997. publicly listed companies relied more on new equity financing than privately.1 50.3 48. This financing pattern supports the earlier finding that foreign-owned companies had the highest leverage among the three types of companies.5 27.4 43.8 16.0 53.9 16.4 2. especially bank loans. Foreign-owned companies relied more heavily on debt financing.0 9.0 6.17 Composition of Assets and Financing of the Publicly Listed Sector.2 100.17.5 41.000 Corporations in the Philippines.6 48.9 3.1 9.6 26.and foreign-owned companies.7 13.5 16.3 12.2 100.9 38.2 51.0 1995 1996 13.9 16.0 Source: SEC-BusinessWorld Annual Survey of Top 1.8 51.8 3.4 12.6 0.3 11. significantly Table 3.8 0.0 13.0 10.1 15.7 23.8 100.3 12.1 7.7 100.9 12.7 7.4 100.9 0.3 13.Chapter 3: Philippines 205 average. A breakdown of the financial structure of publicly listed companies measured in balance sheet items is shown in Table 3.
the current ratio. Group companies were generally more profitable than independent companies.000 Corporations in the Philippines. the average SFRF of business groups was higher compared with that of independent companies. As shown in Table 3.3 0.3 0. and economies of scale in fund raising. The SFRF for independent companies would have been even lower if the highly profitable foreign-owned companies were excluded. their inherent ability to pool risks.5 0. group companies usually financed their investment in member companies by equity rather than debt. II in 1996 and became more vulnerable to the financial crisis in 1997. indicating that many publicly listed companies were likely to be in a tight liquidity position. 1988-1997.206 Corporate Governance and Finance in East Asia. Further. group companies were less reliant on debt financing than 13 Defined as total current assets divided by total current liabilities.5 Excludes negative balances Source: SEC-BusinessWorld Annual Survey of Top 1. For these two reasons.45 in 1996. The normal standard liquid position is a current ratio of 2 or higher. The traditional measure of liquidity. for independent companies.5 0. On average. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Group Member 1.9 0.13 was at 1.3 0. respectively. Corporate Financing by Control Structure Conglomerates have certain advantages in financing because of the opportunities offered by the internal capital markets. as opposed to 94 and 30 percent. compared with an average of 54 percent for independent companies.1 0. .6 Independent Company 0. retained earnings financed 113 percent of growth in fixed assets and 23 percent of growth in total assets from 1989 to 1997 for business groups.2 0.18. Group companies financed an average of 45 percent of growth in total assets by debt. the easier access to external credit. Vol. Table 3.18 Financing Patterns by Control Structure.
06.3 0.6 0. equity financed 42 percent of incremental asset growth.9 0. The medium-sized companies’ high debt financing ratio was due mainly to three years of complete reliance on debt to finance growth.6 0. There was also increased reliance on debt financing.1 0.5 0.08 and SFRT of 0.88 for large companies (Table 3.50 (Table 3.3 0. Large firms consistently increased their reliance on debts from 1994 to 1997. 1993 with 96 percent.2 0. 1988-1997.000 Corporations in the Philippines. with an average of 3. compared with 55 percent for large companies and 47 percent for small ones. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Large 0. medium-sized companies used more debts. and 1997 with 131 percent. Table 3. Corporate Financing by Industry The manufacturing sector had an average SFRF of 1.5 Medium 3. averaging 61 percent of growth in total assets.19 Financing Patterns by Firm Size. With assets growing at a fast pace during this period. Corporate Financing by Firm Size SFRF was highest for medium-sized companies.2 0. 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). The lower SFRF for large companies may be caused by their larger outlays for growth in fixed assets.47.2 0.Chapter 3: Philippines 207 independent companies.4 Small 0. Excluding .3 0.20).5 Excludes negative balances. Source: SEC-BusinessWorld Annual Survey of Top 1. Large companies’ IDFR of 0.55 was substantially higher than the small companies’ 0.76 for small companies and 0. These years were 1991 with 110 percent. On average.8 0. The corresponding ratio was 0.
20 Financing Patterns by Industry.4 0. Low incomes diminished the equity financing position of the manufacturing industry toward the crisis year. the total debt ratio was much higher in 1996 at 0. the manufacturing industry financed 57 percent of its total asset growth by debt.04. Up to 1997.79 and in 1997 at 0.27. Its SFRF and SFRT were volatile because of chronic losses and reduction in fixed and total assets.58 and SFRT of 0. The effects of the crisis of 1997 were adverse.5 Utilities and Real Estate Services and Property 0. II 1991. debt financed about 78 percent of asset growth in real estate.47 two years later. Equity financed the rapid expansion in the industry’s assets in the period 1994 to 1997. The real estate industry financed its growth by substantial equity funds. . Table 3.6 a Excludes negative balances.4 0.6 0.7 0.5 (0. achieving an average SFRF of 3. while SFRT averaged only 0.6 0. 1989-1997 Financing Indicators Manufacturing SFRFa SFRTa NEFR IDFRa IEFRa 1.3 0. The utilities sector showed weaknesses in internal fund generation in 1989-1994. Excluding 1997 when fixed assets declined. In the eight years preceding the crisis.208 Corporate Governance and Finance in East Asia.3 0.5 0.000 Corporations in the Philippines.6 0.4 3. Incremental equity financing amounted to an average of 44 percent of total asset growth. the industry generated internal funds. Vol.2) 0. While this level is considered prudent.32.91.4 Construction 0. The sector had the highest leverage among all industries that year.3 0. SFRF for the sector averaged 0. ranging from 41 to 118 percent.4 0.1 0. Equity financed an average of 62 percent of total asset growth. with an SFRF as low as 0.29. The situation improved beginning 1994. Source: SEC-BusinessWorld Annual Survey of Top 1. During the crisis year.3 0. many of the leading real estate companies successfully went public during that time. when debts declined. the incremental equity ratios of the industry were high.5 0. 1988-1997. Total liabilities increased partly as a result of the local currency devaluation and financed all of asset growth for the year. increasing to 0. Since the real estate boom coincided with that of the stock market. The construction sector was a heavy user of debt financing.
. alternatively. and financial leverage are all positively and significantly related to the degree of ownership concentration. and Performance Previous studies on corporate governance have often associated ownership concentration with heightened risk-taking by companies. the coefficient of the ownership concentration measure in all the three regressions is positive and statistically significant. measured by the percentage of shareholdings of the largest five shareholders.769 0. creditors bear the consequences. Using the PSE database. as the dependent variable.287 0. Journal of Finance 48: 831-880. and the Failure of Internal Control Systems. while if it fails.004 3.008 5. 1992-1996. was regressed against measures of profitability and of financial leverage.4. Financial Leverage. ROE. and leverage. the degree of ownership concentration. 14 See for example Michael Jensen (1993). more profitable.00036 2. The Modern Industrial Revolution. Exit. at the same time.21.230 Leverage 0.14 Large shareholders may borrow excessively to undertake risky projects. and Financial Leverage Dependent Variable Item Coefficient of Ownership Concentration T-statistics Adjusted R-squared F-statistics ROE 0.21 Ownership Concentration. As shown in Table 3.Chapter 3: Philippines 209 3. These results suggest that companies with higher ownership concentration tend to be more highly leveraged and. ROA.130 ROA 0. ROA = return on assets.3 Ownership Concentration. Table 3. knowing that if an investment turns out to be successful they could capture most of the gain. Three regressions were run with the shareholding of the largest five shareholders as an independent variable and ROA. ROE. Source: Author’s estimates based on the PSE databank. Profitability. ownership concentration = the total shareholdings of the top five shareholders.421 0.860 Leverage = the ratio of total assets to total equity.00056 1.009 5. ROE = return on equity.00125 2. Large shareholders may also overuse financial leverage to avoid diluting ownership and control.
the growth in foreign investments fueled that of the manufacturing and services sectors in the years preceding the crisis.” The Government’s judgment that economic fundamentals were strong was based on stable growth rates. The largest contributors to GDP were services at 43 percent.5. which averaged 4.210 Corporate Governance and Finance in East Asia.5 percent per year from 1992 to 1997. In sum. raw materials. with a narrow exporting industry base. foreign investments in the country have been low. the country’s GDP growth pace indicated that it did not have a “bubble economy. 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. Garments was the second largest export sector at about 9 percent. Net investment inflows were $3. Commercial and industrial activities in the country were largely oriented to domestic markets. and intermediate goods. industry at 34 percent. more than half (52 percent) of exports were semiconductors. Manufactures accounted for about 85 percent of exports. II 3. Vol.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. Compared to other East Asian crisis-affected countries. notably remittances of overseas workers. with commodities accounting for the balance.8 percent of GDP from 1995 to 1997. About 80 percent of imports were capital goods (particularly power generating and telecommunications equipment).” that is.5 3. The structure of the economy may be understood by looking at its sectoral composition and export competitiveness. Exports were growing at about 20 percent per year in the three years preceding the crisis. and agriculture at 21 percent. the economy still showed vestiges of its import-dependent and substituting character. The Government explained that the country had “sound economic fundamentals” but that the problems were caused by “contagion. the country was less dependent on foreign private capital. Net trades in goods and services averaged a deficit of 4. but its share had been declining by 4 percent per year since 1995. The export sector had a very narrow breadth. their growth gathering momentum only beginning in 1992. Although much lower than those of other Asian countries. In 1997.5 billion in 1996 and grew at an average of 48 percent per annum from 1992 to 1996. The country experienced balance of payments surpluses but these were due to transfers. Historically. an overexpansion of capacities. After a . Because of limited local capital.
adjustments were focused on the quantity and quality of the banking system’s corporate loans. while sales grew by only 20 percent per year.1 percent. The corporate sector was in a relatively stable financial condition around the time of the crisis. Five years of stable growth before the crisis enabled the country to build its net international reserves to $10. the ratio of short-term debts to international reserves dipped below 100 percent beginning June 1998. and a relatively healthy banking system. in turn. assets grew at a compound annual rate of about 31 percent. Since the regional financial crisis was triggered by the loss of confidence in some East Asian economies by foreign creditors and investors. After hovering in the range of 100 to 127 percent. Eventually. which. The lessons from debt restructuring became the basis for the Government’s economic policies. Prudent fiscal management and controls on foreign borrowings were part of the adjustments required by IMF and foreign creditors. shows that investments of the corporate sector were growing at a faster rate than sales revenues in the years immediately preceding the crisis. 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. In the Philippines. fueled also by successful IPOs during the stock market boom of 1993-1996. however. The adverse impact of the crisis in most Asian countries was proportional to the amount of short-term foreign debts relative to net international reserves. The Central Bank conserved international reserves by allowing the local currency to float within a wider trading margin. . unlike their counterparts in the region.3 percent. During this time. Economic performance during 1992-1997 was characterized by an average growth rate of real gross national product (GNP) at 3. resulting in stability in the short-term debt to reserves ratio. depended on the quality of the corporate sector’s investments. an average inflation rate of 7.8 percent. From 1988 to 1996. the country and the corporate sector had no access to foreign currency debts from the international financial market. Closer analysis. a positive balance of payments from 1992 to 1996. an average Treasury bill rate of 13.Chapter 3: Philippines 211 long period of debt moratorium and restructuring that started in 1983 and ended in 1991. Financial institutions called on their shortterm loans and shortened the maturity of existing loans.5 percent. Profitable operations since 1992 had allowed it to build equity. a government fiscal surplus from 1994 to 1997. From 1993 to 1997. the Government sought stability and achieved this in 19921997.6 billion as of March 1997. the Government restructured its debts into longer tenors with a maximum of 25 years. average ROE was 13. Total debts were only 52 percent of assets or 108 percent of equity.
5 billion in 1995.074 2. the other immediate impact of the crisis was that on foreign investment flows. Data for 1998 cover only January-August. Foreign investments in the Philippines have not been as high as the inflows to other Asian countries—and this. Net foreign investments more than doubled from 1995 to 1996 but declined by 78 percent in 1997 (Table 3. In 1997.073 (406) 121. Net foreign portfolio investment amounted to $1.303 23.5.7 Note: Peso-dollar exchange rates used are: 1995 = 25. mitigated the effects of the pullout and liquidation of investments in the aftermath. It financed 26 percent of corporate capital growth. These patterns in investment and financing are similar to those of other countries in the region. 1995-1998 Item Net Foreign Investments ($ 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. Table 3. The debt level of the Philippine corporate sector in 1997 was low by Asian standards but still high by developed country standards. It rose to $2. 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. Vol.517 1.22 Foreign Investment Flows. It is understandable then that the effect of the Asian financial crisis on the Philippines was correspondingly that of a negative “contagion.650 32. net FDI remained stable at more than $1 billion.0 1996 3.71.718 30. 1998 = 41. .47.22. growing by about 34 percent per year from 1994 to 1997.4 1997 762 1.485 145.101 92.749 26. Debts financed a large part of this expansion.609 1. II The corporate sector indeed overexpanded after 1993 like its counterparts in the region. but to a lesser degree.212 Corporate Governance and Finance in East Asia.300 1. Most of this leverage happened during the boom years in the region. or 114 percent of net foreign direct investment (FDI).0 1998 739 555 328 69. 1997 = 29.06. precisely.2 Impact of the Crisis on the Corporate Sector Aside from the foreign exchange adjustment.22). In sum.101 billion or 196 percent of net FDI in 1996. 1996 = 26. But portfolio investment amounting to $406 million flew out of the Philippines.” 3. Sources: Bangko Sentral ng Pilipinas and SEC.
The resources of the financial system that year totaled P3. Loan calls. Lending rates were well above the 20 percent level from July 1997 to March 1998. in varying degrees for each sector. with commercial banks holding P2. they could not initiate a large reduction of their loans because these in part financed long-term growth in assets. Bank loan pricing was based on the bellwether 91-day Treasury bill rates rather than inflation.2 percent in November 1997. they were willing to restructure and renegotiate existing loans by corporate borrowers. By October 1998. meanwhile. Although corporate borrowers were not highly leveraged. Bank spreads over Treasury bill rates increased in 1997 but were within the range experienced in the past. albeit at current market interest rates.369 billion. When the Treasury bill rates eased in March 1998. Manufacturing reduced its loans outstanding by 11 percent from October 1997 levels.9 percent. sparking a rise in interest rates on corporate loans. and leverage increased to 149 percent compared with 109 percent in 1996. the corporate sector became vulnerable to loan calls and high interest rates.2 to 28. By March 1988. ROE at 6. Because commercial banks were strongly capitalized. 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. the sectors with the highest outstanding loans had reduced their credit exposures. A number of small banks closed but they represented less than 1 percent of the financial system’s total resources.2 percent was barely above inflation rate. The banking system was able to absorb the impact of the crisis primarily because of its strong capital position. The interest rates on Treasury bills. ranged from 11 to 13 percent from 1993 to July 1997. and the wholesale and . new borrowings financed asset growth.3 percent of assets. With the increase in borrowings and reduced liquidity. then rose to a high of 22. Companies deferred investments in new fixed assets.513 billion. the commercial banking sector’s capital remained strong at 17. in turn. suggesting that commercial banks required a higher premium at about the height of the crisis but not beyond. Average bank lending rates climbed to their peak of 25.7 percent in January 1998. depended on the liquidity and capital position of commercial banks. which held about 75 percent of the assets of the financial system in 1997. Because of weak internal fund generation. lending rates also came down.Chapter 3: Philippines 213 Corporate financial performances and conditions deteriorated during 1997. Loans outstanding of commercial banks declined by the first quarter of 1998. The combined effects of shrinking demand and high interest rates reduced the corporate sector’s demand for loans.
This allowed the Central Bank to convince the banks. In March 1997. Vol. by 12 percent. As for nonperforming loans (NPLs).9 percent of bank loan portfolios. and subsequently went down to 13. The Central Bank introduced regulations on foreign exchange trading to control speculation and nondeliverable forward contracts. single-digit NPL ratios began only since 1989. was a problem sector. The Central Bank adopted other measures to strengthen the financial system. through the Bankers’ Association of the Philippines. loans outstanding of the real estate sector increased by 11 percent from June 1997 to June 1998. and set up a hedging facility for borrowers with foreign currency-denominated loans. The pattern indicates that real estate loans were of substandard quality but banks had contained the problem by mid-1998. the ratio increased to a high of 11. The latter measure was especially beneficial to companies with unhedged foreign currency loans from commercial banks.3 Responses to the Crisis Government Responses The Government’s policy and regulatory responses to the crisis focused on monetary and credit issues. 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. including (i) a regulatory limit of 20 percent on banks’ loans to the .5. 3. II retail trade sector. to reduce their lending spreads over the 91-day Treasury bill rates from 3-8 percent to 1.5 percent by September 1998. However. The move retained the liquidity position of banks but lowered their cost of reserves. 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 the financial system.214 Corporate Governance and Finance in East Asia. Still.6 percent in June 1998. But the Philippine banking system had gone through worse crises in the past. thereby reducing overall intermediation costs.5-6 percent. real estate loans averaged 11. as with its counterparts in other Asian countries. These peaked at 14.3 percent in December 1997. This “voluntary agreement” partly explains why the loan spreads of banks were within the range of recent experience. and its experience of low. These figures show that adjustment problems were industry-specific and that the real estate industry. the fiscal position. set limits on overbought/oversold foreign exchange positions of banks.
PAL. (iii) fixing loan loss provisions of 2 percent of the gross amount of loan portfolio on top of individually rated bad loan accounts. A 40 percent devaluation of the Philippine peso lowered the purchase price of PLDT to foreign investors. (v) improving disclosure requirements on the financial position of banks. the Asian crisis opened a unique opportunity for foreign investors. The acquiring company. Average Treasury bill rates have cooled since mid-1998. subcontracting and outsourcing. changing technologies. (iv) increasing banks’ capital requirement by 20 percent for universal banks (banks with expanded licenses) and 40 percent for ordinary commercial banks. was known to have a policy . In the case of PLDT. With its weakened financial position. (PAL). the Government kept inflation below 10 percent. Large companies with heavy loan exposures such as Philippine Airlines Inc. The real estate portfolio of commercial banks also declined and was well below the Central Bank’s regulatory ceiling by March 1998. First Pacific Corporation. consolidating business units. In response to calls for lower bank intermediation costs. (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. The policy directions and actions taken by the Government appear to have ushered in recovery. Responses of the Corporate Sector The corporate sector’s financial position. and (vi) issuing guidelines on duties and responsibilities of banks’ boards of directors for improved quality of bank management. its accessibility to foreign capital. The economy avoided a recession in 1998 and achieved 3.6 percent growth in 1999. bank loan rates have also come down. came up with a rehabilitation plan by May 1999 that was found acceptable to all parties.Chapter 3: Philippines 215 real estate sector. With prudent monetary management. took more action. the largest telecommunications setup in the Philippines. and giving up noncore businesses. Takeovers in the past involved cooperative negotiations between purchasers of a target company and family-based large shareholders. the country’s flag carrier. Publicly listed Philippine companies could also be restructured through takeovers by local and foreign investors. Financially strong companies were able to survive the crisis by effecting such internal restructuring. which was privatized with the Lucio Tan group gaining control and the Government retaining minority ownership. 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.
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. concentrated ownership of companies is not equivalent to weakness in corporate governance.6 3. Its stock price and returns to shareholders had stagnated. By itself. 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.216 Corporate Governance and Finance in East Asia. One mode was the outright purchase of shares in the open market. Conclusions.1 Summary. Consequently. is whether there are sufficient safeguards to prevent controlling shareholders from . The question. at a premium over the market price to reflect the value of management control. Corporate governance is conditioned by the high ownership concentration of these large companies. II of investing to control companies that are dominant players in their industries. Ownership is highly concentrated and a few dominant players control major industries. First Pacific. SMC is another widely-held company managed by a minority shareholder. In a legal process that ended in his takeover of management. SMC had lagged behind other groups of companies such as Ayala Corporation in financial performance for some years. First Pacific could have acquired sufficient shares to take control of PLDT in three ways. A second method was to purchase the shares of other large minority shareholders. 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. Although considered the prime industrial company in the Philippines.6. using some or all of these means. When companies are highly profitable. and Recommendations Summary and Conclusions The Philippine corporate sector has been shaped by the country’s economic and industrial development policies. When Cojuangco took over. the Cojuangcos. the Soriano family. he restructured the company toward its core brewery business and sold off local and foreign subsidiaries. 3. Vol. controlling shareholders can capture these profits by excluding public investors from ownership. however. the stock price of PLDT was buoyant during the takeover period. Eduardo Cojuangco was able to assert his ownership of shares taken over by the Government during the transition of power in 1986.
an underdeveloped capital market. Analysis of corporate financing by ownership . minority shareholders need to be protected by external control mechanisms. passive independent auditing. Performance was. companies that are members of family-based conglomerates had higher returns and lower leverage than independent companies. The result is that corporate governance depends only on internal controls. Leverage was within Asian norms but above developed country standards. oligopolistic market structures. Business groups occupied seven of the top 10 and 25 of the top 50 largest corporate entities in the Philippines in 1997. ownership of banks by business groups. This study points out weaknesses in external control mechanisms such as weak legal protection for minority shareholders. were the least profitable. foreign companies were the most profitable but highly leveraged. The Philippine corporate sector was relatively efficient in investing and financing compared with other countries affected by the Asian crisis. and the lack of market for corporate control. Returns to capital exceeded inflation rates. The five largest shareholders have majority control of an average publicly listed company. Privately-owned companies. Corporate governance should be viewed in the context of an increasing presence and growth of large shareholders-centered conglomerate business organizations. with the real estate and public utilities industries standing out for their pronounced cyclical patterns. while the largest 20 shareholders control more than 75 percent of shares. The financing pattern of the corporate sector was influenced by the tight financial conditions prevailing in the country up to 1992. to some extent. This study analyzed trends in corporate performance and financing in relation to corporate governance from 1988 to 1997.Chapter 3: Philippines 217 expropriating the wealth of minority shareholders through aggressive and risky investment. the most numerous in the corporate sector. By size. By ownership structure. an ineffective insolvency system. influenced by industry characteristics. By control structure. Financial institutions are not significant shareholders. Publicly listed companies had the highest profit margins and lowest leverage among the local companies. Ownership of publicly listed companies is highly concentrated. medium companies showed higher profitability than large and small ones. 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. The corporate sector consistently relied on internally generated funds and equity before resorting to borrowings. With large shareholders in control.
and the extent of supervision of outside institutions such as independent auditors and SEC. Even in cases where the group owned only a minority share of a commercial bank. the bank usually accounted for a large share of each group’s net profits. Vol. The extent of governance problems depends on internal control policies of the controlling shareholders. Such structures result in control by large shareholders through disproportionately smaller investments in equity ownership. Internal financial markets operated by business groups allowed them to optimize their financial resources at lower external debt levels. ROE. After controlling for industry effects. ROA. A business group is an effective business organizational model for achieving leadership in industries. as typified by the Ayala Group. Larger disparities in control over cash flow rights imply higher incentives for large shareholders to (i) expropriate wealth of shareholders not belonging to the controlling group and (ii) invest in empirebuilding and high-risk projects. and sustained growth. Ownership concentration was positively related to both returns and leverage. and leverage were all positively related to the degree of ownership concentration. statistical analysis of company-level data revealed significant relationships between corporate performance and corporate governance. Large companies owned or controlled by business groups tend to dominate their industries. Business groups with pyramiding structures heighten the issue of corporate governance. . superior profitability. the amount of pressure from stock market investors and PSE (for publicly listed companies in the group). Publicly listed companies were responsive to investors’ requirements for prudent use of debts. family-based shareholders gain control by such means as the setting up of holding companies. selective public listing of companies in the group. with the foreign-owned companies found to rely more on borrowed funds. II type gave similar results. A commercial bank is an important part of most business groups. 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. 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. The difference between management control and ownership rights is usually substantial.218 Corporate Governance and Finance in East Asia. The pyramid model is useful for centrally managing smaller companies. and centralized management and financing.
there were sharp rises in the number of bankruptcies and petitions for debt relief. a strong international reserves position. There are systemic risks involved in highly concentrated ownership. adversely affecting companies’ operations and financial position.Chapter 3: Philippines 219 The financial crisis came when the Philippine economy was in a relatively strong financial position. decide on the financial future of a troubled debtor. decisions by large sharehold- . Under the new Securities Regulation Code enacted in 2000. That is. 3. the government budget in surplus.6. For example. Specific actions recommended are described below. and sound overall creditworthiness. including suspension of payments. rather than the banks that lent millions of pesos. and a market-oriented policy environment. SEC officials. This law is flawed in concept because it supplants a market-based credit agreement with a political process. mostly by highly leveraged companies and speculative investors in real estate. 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. The corporate sector accessed the foreign debt market only in the mid-1990s because of the country’s long-drawn debt moratorium. Still. The crisis caused a tightening of credit to the corporate sector and a spike in interest rates. there was a sharp rise in borrowings and decreasing productivity of investments a few years before the crisis in a pattern similar to that of Asian crisis countries. The Central Bank responded by improving the liquidity of the system and by establishing conditions for bringing down interest rates on bank loans. The corporate sector was also in good financial condition with rich internal cash flows accumulated from a number of profitable years. The Central Bank imposed strict limits on real estate lending.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. A number of large debtors petitioned SEC for rehabilitation under procedures set by PD 902-A. As the crisis wore on in 1998. low inflation. are to be removed and transferred to courts. resulting in the banks’ accelerated restructuring of troubled debts in this sector. with recently restructured public debt. strong capital position built on IPOs in a buoyant stock market. SEC’s quasijudicial functions.
and self-dealing. It has suffi- . Vol. This may limit current practices of appointing prominent individuals and family members as directors. depending on the size of the company.220 Corporate Governance and Finance in East Asia. the PSE Listing Rules require the appointment of a minimum number of independent directors in the board of publicly listed companies. they serve to curb the powers of controlling shareholders. To help ensure this. to 25 percent. (ii) require disclosure of material changes in ownership. 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 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. Another measure would be to impose a statutory limit on the number of directorships that one can accept. II ers often cause wide volatility in stock prices and invite reaction from creditors. Because independent directors tend to adopt the perspective of minority shareholders in board decisions. inadequate disclosures. The adjustment should be made over a fixed period of time. and (iii) increase the minimum required percentage of outstanding shares for public listing in the stock exchange from the present 10-20 percent. insider information. This will enable SEC to enforce prudential requirements on management of companies and enable minority shareholders to pursue grievances against their boards. 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. SEC should strengthen disclosure requirements by issuing specific guidelines on minimum disclosures required for related party transactions. Increasing the Statutory Accountability of Directors and Strengthening the Board System The Government should clarify statutory fiduciary responsibilities of the board of directors. To strengthen the board. Clear legal accountability is a precondition for successful shareholder activism.
the Corporation Code should be amended to impose sufficiently stiff penalties for self-dealings that patently expropriate the wealth of other shareholders.Chapter 3: Philippines 221 cient case history that can be used as a basis for tightening its disclosure requirements. and of banks in nonfinancial companies in order to avoid connected lending. (iv) require banks to follow international financial accounting. (iii) adopt international standards of capital adequacy and ensure that banks comply with these standards. By requiring sufficient disclosure and a 75 percent majority vote on such decisions. and (v) closely monitor. They need legal empowerment such as higher majority voting requirements. officers. It is encouraging that the newly enacted 2000 Banking Laws have introduced changes along these lines. in particular. e.g. The Government should improve its prudential supervision system to ensure that banks perform their role as external control agents of their corporate debtors. prudential measures and regulations. Finally. reporting. Impose severe penalties for any attempt by banks to circumvent this regulation. or prohibit cross-guarantees by companies belonging to affiliated groups. (ii) set strict limits on lending by banks to affiliated companies. fit and .. and disclosure standards. Improving Financial Regulation and Strengthening Implementation The Asian crisis demonstrated the need to strengthen banking regulation. 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. directors. raising the current two-thirds majority to a three-fourths majority. For example. limit. the board can easily muster the needed majority to approve the deal. and related interests. Minority shareholders have failed to use traditional venues such as the annual general shareholders’ meetings to discipline controlling shareholders that expropriate their wealth. current rules allow boards of directors to approve own-dealings or related party transactions by simple majority. Because ownership is generally concentrated in five shareholders. in areas of supervisory functions of the central bank. The following recommendations aim to further improve banking regulations and supervision in the Philippines: (i) limit shareholdings of nonfinancial companies in 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. SEC appears to be taking a primarily regulatory posture in the operation of investment funds. Its priority is to protect prospective fund investors from unscrupulous fund managers. 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. Managements find that their investment and financing decisions affect stock prices and become aware of their responsibility to create shareholder value. This way. an active financial analyst community can begin to form. Presently. Two measures should be adopted to promote shareholder activism. and lending to DOSRI. Investment and venture capital funds meet this description. Vol. One is improved transparency and disclosure on specific items that potentially involve expropriation of wealth of minority shareholders. Institutional investors impose market discipline by voting on strategic corporate decisions. management. Other investors benefit from the information that analysts produce for these institutional investors as information technology makes their output a public good. II proper rule. In developed capital markets. SEC and PSE can help ensure that these external control agents provide market discipline even in companies controlled by large investors. and external auditors. institutional investors can be a driving force in providing market discipline to management. 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. institutional investors lead public investors in providing market signals to companies. If institutional investors are present.222 Corporate Governance and Finance in East Asia. The current law should expand class action suits to include management and . foreign ownership of banks. 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. transparency. By supporting the establishment and operation of institutional investors.
and dividend decisions.Chapter 3: Philippines 223 auditors. Legal provisions for class action suits should cover self-dealing by directors. and broad-based political and popular support to pursue possible cases involving expropriation of minority shareholders’ wealth. Philippine Government Treasury bonds should provide bellwether rates for corporate bonds in the way that they have for short-term bank debts. The Government should enhance the securities markets as an alternative source of corporate financing and pursue aggressive development of the local debt securities markets. Securities market development efforts should coincide with strict regulation of the commercial banking sector. their directors and management. Companies are likely to remain dependent on bank financing if the authorities do not strictly enforce prudential lending regulations. and Credit Information Bureau that can be the starting point of this effort. guarantees. The present provision on class action suits is inadequate because shareholders view the process as ineffective and expensive. where the threat of class action suits alone is sufficient to encourage quality decisions and behavior from management. leadership. 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. and the external auditors. entry . These groups have an incentive to gather technical expertise. Promoting the corporate bond market requires that the Government develop trading systems and services of credit risk rating of corporate issuers. And by issuing Government Treasury securities in longer tenors. 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. There are existing institutions such as Dun and Bradsreet. information disclosures. It should develop a medium-term yield curve for the corporate debt market by strengthening the Government bond market. SEC should allow minority shareholders to be represented by activist groups. compensation contracts. the Government could develop the market for future issues of corporate bonds. Placing the means for prosecuting in the hands of minority shareholders may instill more discipline in controlling shareholders. Promoting Competition in Product Markets The Government should pursue industrial development policies that promote competition through the elimination of subsidies.
II and exit barriers. and various other forms of protection. and publicly listed companies trade barely the minimum number of shares required for public listing. The increase in percentage of public holdings may be gradually implemented to enable the companies to adjust. The Government should also continue to improve infrastructure. SEC should require that a larger percentage of publicly listed companies’ shares be sold to the public. improve enforcement of the rule of law. Current disclosure requirements of SEC are not rigorous enough for public investors. Improving External Audit Standards and Information Disclosure Effective external control in corporate governance requires accurate and timely information about companies. Efforts to reduce graft and corruption. Penalties for poor conduct of auditing by independent . Another problem is the orientation of external auditors to the interest of large shareholders rather than public investors. and provide quality basic services should also be heightened. Vol. PSE and SEC need to build a liquid and efficient market. Little attention is given to the conditions that make those regulations effective in the US corporate sector but not present in the Philippines. 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. The resulting absence of a strong investor base makes share prices vulnerable to manipulation or insider trading by large shareholders. The Government’s competition policies should aim to facilitate the free entry and exit of domestic and foreign companies and regulation of anticompetitive practices. Increasing the Supply of Quality Equities in the Stock Market To promote the capital market as an external control agent in corporate governance.and medium-scale companies can become more competitive relative to large companies. so that small.224 Corporate Governance and Finance in East Asia. there is a need to increase the supply of quality securities from top-tier local companies in the Philippine stock market. Audited financial statements contain basic information about a company’s financial position and performance. Lack of liquidity deters institutional investors. Many large companies remain privately owned. 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.
it creates a moral hazard problem. suspension of payments and private damage actions.Chapter 3: Philippines 225 auditors and the mechanism for imposing them are weak. PD 902-A has not accomplished any successful rehabilitation of a petitioning company since its implementation. violators were made to pay only nominal penalties. review the system of penalties on professionals involved in a company’s violation of disclosure rules. and liquidation of troubled companies should be made a priority of the Government. and implement those standards and penalties rigorously. Reforming the legal framework for suspension of payments. the new law needs to be effectively implemented and enforced. 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. SEC and PICPA need to formulate more specific disclosure standards. including the resolution of intracorporate disputes. . The law on suspension of payments replaces a market-oriented solution with a political process. Instead. For that matter. In spite of the many well-known cases of poorly audited financial statements that resulted in losses for investors. Although the new Securities Regulation Code enacted in 2000 has removed some of SEC’s quasijudicial functions. and Liquidation. and transferred these to courts. SEC and PICPA have not publicly penalized any auditor company that violated disclosure requirements or failed to submit audited financial statements. Improving the Legal Framework for Suspension of Payments. reorganization. Reorganization.
and Larry H. The Separation of Ownership and Control in East Asian Corporations. David J. Bangko Sentral ng Pilipinas. 1998. and Corporate Diversification. and Larry H. Claessens. Journal of Financial Economics 25: 371-395. October. P. Barclay. Claessens. Diane K. P. The Philippines: Onward to Recovery. Pedro. Conference on Thailand’s Dynamic Economic Recovery and Competitiveness. Journal of Finance 2 (1). Simeon Djankov. Dennis. Simeon Djankov. P. Demsetz. Journal of Political Economy 93 (6). II References Abonyi. and Kenneth Lehn. 1985. H. edited by Toida Mitusuru and Daisuke Hiratsuka. and Clifford Holderness. 1999. Equity Ownership. Vol. Manila: Asian Development Bank. Fan. Institute of Southeast Asian Studies. Thailand: From Financial Crisis to Economic Renewal. 1998c. Thailand’s Corporate Financing and Governance Structures: Impact on Firms’ Competitiveness. World Bank. Fan. XXIX. Ownership Structure and Corporate Performance in East Asia. Private Benefits from Control of Public Corporations. March.. Simeon Djankov. Fan. and Larry H. Diversification and Efficiency of Investment by East Asian Corporations. . Joseph P. Large Shareholders. Burkart. Stijn. George. 1998a. and Larry H. Claessens.. Asian Industrializing Region in 2005. Stijn Claessens. Who Owns and Controls East Asian Corporations? Discussion Paper 2054. Working Paper. Alba. 1999. World Bank. Asian Development Bank. Simeon Djankov. 1994. Claessens. Key Indicators of Developing Asian and Pacific Countries 1998. and Fausto Panunzi.226 Corporate Governance and Finance in East Asia. Dennis Gromb. July. Discussion Paper. 1997. Joseph P. Expropriation of Minority Shareholders in East Asia. 1998b. Antonio. Working Paper. Vol. H. World Bank. Agency Problems. Stijn. Lang. Simeon Djankov. Tokyo: Institute of Developing Economies. Denis. The Structure of Corporate Ownership: Causes and Consequences. Jr. Stijn. 1999. M. H. Lang. Quarterly Journal of Economics. P. 693-728. Working Paper 2088. Harold. World Bank. Claessens. Emilio. May. 1997. and Atulya Sarin. 1989. and Simeon Djankov. Joseph P. Joseph Fan. and Larry H. Stijn. Michael. Lang. Lang. Lang. Philippine Macroeconomic Prospects: The Next Ten Years. Monitoring and the Value of the Firm. 1998. P. 1988. World Bank. Stijn.
Michael. Capital Structure and the Information Role of Debt. 1990. Journal of Finance 48: 831-80. Oliver. Corporate Structure. Corporation Finance. Agency Costs and Ownership Structure. 1984. Scharfstein. Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management. Theory of the Firm: Managerial Behavior. 1958. Exit. 1998. and David Scharfstein. Milton. Hoshi. 1990. and Artur Raviv. David S. Robert H. Review of Economic Studies 51: 393-414. Lufkin.Chapter 3: Philippines 227 Diamond. Stuart. and Jeremy C. Stephen. and David Gallagher (eds. Modigliani. Michael. Douglas. 1983. The Market for Corporate Control: A Scientific Evidence. Jensen. American Economic Review 76: 323-29. Joseph C. 1986. 1976. Anil Kashyap. International Corporate Governance. 1995. Stein. F. Myers. Financial Intermediation and Delegated Monitoring. 1994 and Investment Guide 1997. and John Moore. Internal versus External Capital Markets. Determinants of Corporate Borrowing. Jensen. Franco. Institutional Investment Patterns and Corporate Financial Behavior in the United States and Japan. and Richard Ruback. Prowse. Stephen. Jensen. Prowse. 1995.. The Cost of Capital. Philippine Stock Exchange Fact Book 1997. Journal of Financial Economics 3: 305-360. Journal of Financial Economics 11: 5-50. 1991. 1977. Michael. November. 1993. Jensen. and the Theory of Investment. Journal of Financial Economics 27: 4366. 1994. American Economic Review 85: 567-85. American Economic Review 48 (3): 261297.). Corporate Finance and Takeovers. Journal of Financial Economics 5: 147-175. and the Failure of Internal Control Systems. Corporate Governance: Emerging Issues and Lessons from East Asia. Harris. . Takeo. 1990. The Modern Industrial Revolution.. Quarterly Journal of Economics 106: 33-60. Agency Costs of Free Cash Flow. Journal of Finance 45: 321-350. Liquidity and Investment: Evidence from Japanese Industrial Groups. The Quarterly Journal of Economics. and William Meckling. Hart. Michael. Euromoney Books. and Merton Miller. Gestner. World Bank.
Shleifer. Journal of Political Economy 94: 461-88. Washington. and Robert W. DC. Webb. 1997. 2. November. Mimeograph. Vol. Stiglitz. A Survey of Corporate Governance. 1. Ajit. . 1998. Shleifer. David. Vishny. Stephen. and Robert W. Stein. DC. 1991. 1992. 1997. Andrei. Technical paper No. Credit Markets and the Control of Capital. 1998. 1985. 1996. No. Internal Capital Markets and the Competition for Corporate Resources. Jeremy C. How Do Large Corporations in Developing Countries Finance their Growth? Corporate Financial Structures in Developing Countries. Journal of Finance 91: 1121-1139. East Asia: The Road to Recovery. Some Conceptual Issues in Corporate Governance and Finance. Journal of Finance L11: 737-783. Singh. The Structure of Ownership in Japan. Vishny. II Prowse. Large Shareholders and Corporate Control. No. IFC/WB. Joseph E. World Bank. Journal of Finance LII. Washington. May. and Banking Lecture 17.228 Corporate Governance and Finance in East Asia. March. Andrei. Journal of Money. Credit. Asian Development Bank. 1.
Instead of serving as a buffer between the large inflow of foreign capital and the corporate sector. Asian University of Science and Technology. the Thai Government conceded and adopted a floating exchange rate regime. The fixed exchange rate policy. both of ADB. David Edwards. and Philippines all depreciating significantly. annual short-term capital inflows to Thailand were equivalent to 7-10 percent of gross domestic product (GDP). Thailand. coupled with financial liberalization and deregulation in the absence of an effective regulatory and supervisory system. The author wishes to thank Juzhong Zhuang. Thailand’s crisis exposed similar vulnerabilities in other East Asian economies. but also the stalling of East Asia’s “economic miracle. The crisis in Thailand stemmed directly from unsound macroeconomic policies and imbalances.” After mounting an aggressive defense of the currency. poorly regulated and sheltered from competition. the Stock Exchange of Thailand for its help and support in conducting company surveys. 1 Associate Professor.1 Introduction In May to July 1997. had been plagued with prudential problems for a long time.4 Thailand Piman Limpaphayom1 4. short-term private debt obligations grew to about 60 percent of total private sector debts. the banking system merely validated the financial risks. heralding not only a financial crisis in the country. . with the currencies of Indonesia. The banking system. magnified the impact of these problems on the economy when the crisis hit. Faculty of Business. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. Korea). As a result. Thai corporations were collectively overexposed to exchange rate risks. Republic of Korea (henceforth. It was inefficient in financial intermediation. Malaysia. The corporate sector also contributed significantly to the crisis. the Thai baht came under pressure from speculative attacks. and Lea Sumulong and Graham Dwyer for their editorial assistance. with Thai corporations overutilizing short-term foreign currency-denominated loans. In the prelude to the 1997 crisis. For the period 1994-1996. But it also laid bare weaknesses in both the financial and corporate sectors. The majority of these debts were not properly hedged. Chonburi.
Key factors that led to weak corporate governance include the ineffectiveness of the regulatory framework. The study then considers policy recommendations with emphasis on corporate governance improvement. Section 4. Vol.2 discusses the development of the Thai corporate sector under the National Economic and Social Development Plans. the Government implemented major infrastructure projects and modified its tax policy to encourage capital investment and savings. with government policy providing support but avoiding direct interference. focusing mainly on the companies listed in the Stock Exchange of Thailand (SET).1 Overview of the Corporate Sector Historical Development The corporate sector has long been considered the engine of Thailand’s economic growth. . The country initiated national economic development planning in 1961 when the economy was growing rapidly. Section 4. Section 4. 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. Section 4.230 Corporate Governance and Finance in East Asia. and a family-based corporate ownership structure. II There is now a consensus that weak governance was partly responsible for the corporate sector’s poor financing and investment practices. its growth and financial performance. 4. while new industries were encouraged to reduce the need for imports. The First and Second Plans (1961-1971) Under the first two plans.5 discusses how the corporate sector contributed to the financial crisis and looks at its impacts.3 looks at corporate ownership patterns that resulted in inadequate protection for minority shareholders and weak corporate governance in Thailand. This study examines these and other factors that might have weakened corporate sector governance in Thailand.2. as well as its legal and regulatory framework. To protect domestic industries. the Government increased tariffs on products that could be produced locally.2 4. 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.
with the agricultural sector the major contributor. At the same time. the current account registered a surplus in 1986. helped offset these deficits. The Government decided to embark on restructuring measures in the Fifth Plan (1982-1986) to rehabilitate the ailing economy. resulted in increases in the current account deficit. Average growth for the period was 4 percent per year. Inflation reached 15. processed steel. However. Inflation levels were low. capital inflows. The results were increased exports. 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. Consequently. and reduced current account deficits. The Government had to shift emphasis to restoration of economic stability. however. Thus. lower than anticipated due to a worldwide economic recession. and increases in world food and oil prices. In the wake of lower world oil prices and the rapid growth in income from the tourism and travel industry. The average budget deficit reached an all-time high of $2.6 percent per year. Budget deficits also increased throughout the Fourth Plan.4 billion from overseas and increased taxes on numerous items. including luxury goods. an improved trade balance. the industrial sector grew at a faster rate than the agricultural sector. including a weakening of the dollar. Industrial sector growth was also rapid and many industries (tires. the value of the baht remained stable. it proceeded with its development plan for the industrial sector. To close the fiscal gap. the Government borrowed $6. . chemicals. especially foreign aid from the United States. however. The Third. The decline in imports was steady. External factors. leaving the Government no choice but to resort to overseas borrowings. Fourth.Chapter 4: Thailand 231 During this period.3 percent in 1974. using tax policy to control prices of consumer goods and implementing several price control measures to curb inflation.15 billion per year or 4. the government’s debt burden escalated. Unemployment. As a result. canned foods. and automobile assembly) emerged. But the sustained importation of heavy machinery and equipment resulted in large trade deficits. The focus shifted to export promotion. with the devaluation of the baht in 1984 a major step in this direction.4 percent of GDP. averaging 1.5 percent in 1973 and 24. became a major problem as domestic investment declined. Budget deficits remained a major problem during the Fifth Plan. textiles. gross national product grew by about 7 percent per year.
II The Sixth Plan (1987-1991) Industrial sector productivity improved gradually during the Sixth Plan period. an oversupply of housing emerged. With loans increasingly becoming expensive and hard to come by due to a lending squeeze by the central bank and high interest rates. the bulk of domestic investments went to speculative ventures such as real estate. On top of its predominantly “borrowed” nature. Growth rates during 1987-1991 ranged from 9.7 and 11. combined with its liberal financial policies. By 1995. From 1989. Europe. Thailand’s rapid growth up to the mid-1990s made the country one of the world’s fastest-growing economies. rather than to productive activities.5 percent. averaging 10. Vol. Average annual growth in real GDP was 8 percent. .2 and 13. Inflation was 4.6 percent. The country also attracted a large amount of foreign direct investments (FDIs). from only $31 billion in 1992.6 percent target of the Seventh Plan. reaching an annual inflow of $2 billion in 1991.4 percent targets.8 percent.232 Corporate Governance and Finance in East Asia. The exchange rate was steady at around B25 to the dollar. The Seventh Plan (1992-1996) The economy’s performance from 1992 to 1996 generally met the targets of the Seventh Plan.8 percent. The country’s high ratings in the international capital market. and Hong Kong. The manufacturing sector became a dominant force in the economy. China—went to export-oriented manufacturing industries.2 percent target.2 percent per year. better than the 5.5 to 13. Private sector investment grew at an average annual rate of 7 percent. compared with the 14. and the stock market. Singapore. respectively. lower than the target of 8. increasing its share in total export value from 42 to 76 percent. invited a deluge of capital seeking profitable investments. Most of the FDIs—originating mainly from Japan. the property sector began to collapse in 1996. Growth of exports and imports averaged 14. United States. compared with the 8. Thailand became a debtor’s market. Key to this growth performance was the government’s adoption in 1993 of an aggressive program for attracting foreign capital to finance domestic investments. with private foreign debt reaching $92 billion by the end of 1996. property development. while exports expanded considerably. compounded by a slump in property sales. the Government successfully balanced the budget and even settled its foreign debt of $4 billion before this was due.
with growth shrinking from 23. In his report. Sidney M. 4. The deficits caused the Government to rely on even more external borrowing. the signs of an economy about to falter were there. Under the 1962 Commercial Banking Act. the Government amended the “Announcement of the Executive Council No. a policy that held throughout the first six economic development plans. And because the Government considered the banking system vital to the development of the economy. The country had a current account deficit of about 8 percent of GDP in 1995 and 1996. 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. Foreign banks were barred from competing directly with domestic banks. the Bank of Thailand and .3 percent in 1996.8 percent in 1995 to 1. 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. In May 1974. A series of increases in customs and excise taxes on luxury imports did little to stem rampant consumer spending. Before the capital market emerged. the establishment of the Securities Exchange of Thailand (SET) was legislated and trading began on 30 April 1975. Exports went into a tailspin. the capital markets didn’t play a significant role until 1975. 58 on the Control of Commercial Undertakings Affecting Public Safety and Welfare. placing all publicly listed companies under regulation. on account of an overvalued baht that weakened export competitiveness. which was amended in 1979 and 1985. many companies considered the Act too restrictive and a hindrance to growth. SET officially became “the Stock Exchange of Thailand” in 1991. the corporate sector’s main source of funding was the banks.” extending its control and regulatory powers to the finance and securities companies operating freely at the time. which raised the debt service ratio. In 1969. Robbins. In 1978.2. However.Chapter 4: Thailand 233 Toward the end of the Plan period.2 Development of Capital Markets Although the corporate sector has long been the government’s main tool for economic development. In 1972.” which later became the master plan for the development of the Thai capital market. a former Chief Economist from the US Securities and Exchange Commission. its policy had always been to protect domestic banks. Its most crucial role was to help mobilize funds to support Thailand’s industrialization and economic development. the Government passed the Public Limited Company Act.
With the liberalization of financial markets. to cater specifically to its . Economic growth had been rapid and domestic savings could not keep up with the pace to support investments. In the 1990s. there were 29 commercial banks (15 domestic and 14 foreign banks) in Thailand. The pressure dovetailed with the Government’s intention to make Bangkok one of the financial centers of the region. Laws were enacted to stimulate growth of the corporate sector. and new financial instruments. Externally.234 Corporate Governance and Finance in East Asia. The regulatory measures were inadequately designed and poorly enforced. increased financial market activities. Thai banks gained access to a variety of funding sources from around the world. the World Bank had recommended such a move. At the end of the Sixth Plan. The banks and finance companies operated at insufficient levels of reserve capital and were overexposed in high-risk businesses such as real estate. the financial and banking laws were generally ineffective. it usually relied on “moral suasion.” The Government also granted financial institutions overly generous bailouts. While the Bank of Thailand had the regulatory power to influence business practices. Financial deregulation and liberalization allowed the country to attract foreign savings and investments that helped finance the growth of the economy. Vol. The resulting availability of funds propelled the corporate sector’s growth through the early part of the 1990s. and the General Agreement on Tariffs and Trade (GATT) meeting in Uruguay had the liberalization of financial services on its agenda. the Government was under international pressure to deregulate the financial sector. Earlier. while the Securities and Exchange Act (SEA) the same year sought to improve capital market supervision. 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 Public Company Act of 1992 relaxed some of the rules and restrictions contained in the original laws. creating a moral hazard problem—the perverse expectation that imprudent bank behavior would be rewarded with forbearance and bailout. However. A number of internal and external factors contributed to the Thai Government’s acceptance of the IMF’s Article VIII agreement. Thailand discarded controls on foreign exchange transactions and capital flows—a turning point for the Thai corporate sector. Thailand’s capital market entered a new era with improved legislation and regulation. II the Ministry of Finance had full authority to supervise all commercial banks.
5 791.394. however.0 19.1).5 111.5 50.9 16.0 21.291. in that order.3 83. with B1. Gas. Real Estate. about 661 companies with total registered capital of B2. In terms of capital. the financial sector is the largest.1 trillion and paid-up capital of B1.2 Type of Business Agriculture. and wholesale/ retail trade and restaurant/hotel sectors.101.1 78.6 350.9 261. The manufacturing sector is a far second with registered capital of B350 billion and paid-up capital of Table 4. Financial deregulation and liberalization were key to realizing that vision. 1978-2000 Number Registered of Capital Companies (B billion) 5 6 245 5 13 129 22 194 42 661 1. 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.6 2. Storage.2 11.9 1.0 Paid-up Capital (B billion) 1. and Communication Financing.6 1.6 23. Hunting. Insurance.1 Public Companies Registered. The stock market boom from 1991 until the financial crash of 1997 reflected international investors’ response to Government policies.3 trillion have been registered with the authority (Table 4. Thailand. the country became recognized as an economic development model for other emerging economies.1 30. and Water Construction Wholesale and Retail Trade. The majority of the companies are in manufacturing.Chapter 4: Thailand 235 fast-growing neighbors. Worldwide. 4. and Fishing Mining and Quarrying Manufacturing Electricity. Ministry of Commerce.2.9 34.4 trillion in registered capital and B791 billion in paid-up capital. and Business Service Community. Social and Personal Service Total Note: The data for 2000 is as of October 2000.0 110. Forestry. finance. and Restaurants and Hotel Transport. 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. Source: Department of Commercial Registration. .
6 7.1 286.1 599.3).2).4 34.4 96. After the passage of the SEA of 1992. respectively.6 39. 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 1.3 31. reducing the value of offerings to a little more than a quarter of the previous year’s level.2 12. Domestic and offshore debt issues reached B54.236 Corporate Governance and Finance in East Asia.8 201. With the enactment of the SEA of 1992 that brought suppliers of finance services and their clients together. meanwhile.3 22. the year before the crisis struck.6 — = not available. The number of listed companies and securities steadily increased until 1996 (Table 4. allowed Thai financial institutions and corporations to obtain funds overseas.6 8.7 136. Source: Key Capital Market Statistics. The stock market also became an invaluable source of funds for corporations. These peaked at B89.3 6.9 1998 1999 15.1 54. the capital market became instrumental in the rapid growth and development of the corporate sector. the value of public offerings rose steadily.0 0.5 — — 56. Table 4.7 7.5 1. Market capitalization.2 40.8 — 26.8 151.7 9.1 2. reached .7 5. reaching a precrisis peak in 1996 (Table 4. moreover. The development of the corporate sector closely followed the development of capital markets.8 billion. While a rebound was apparent beginning in 1998. Vol.1 — — — 6.6 174.3 194. this was due to the recapitalization of commercial banks in compliance with the new loan provisioning requirement.3 1996 1997 65.8 1995 64. The 1997 crisis battered the primary market for securities. Debt market activities also increased significantly with the establishment of the Bond Dealers’ Club (BDC) in 1994.7 27. The preeminence of the financial sector is a direct result of financial deregulation and liberalization.7 billion in 1996. II B261 billion.0 1994 82. Securities and Exchange Commission of Thailand.4 51.7 billion and B27.4 277.2 25.0 20.9 31.9 37.5 1.2 5.2 Public Offerings of Securities. from only B20.5 39. The signing of Article VIII with the IMF.5 billion and B1 billion the previous year.
corporate profitability had been declining. By the early 1990s. and gross profit margin. then stalled in 1990.325 3.535 1.Chapter 4: Thailand 237 Table 4.3 percent in 1989 to 3. Source: Securities and Exchange Commission of Thailand. Corporate profitability. however. as measured by return on assets (ROA). The financial leverage of all companies declined until 1994. when long-term debt grew as Thai corporations began to borrow heavily to finance growth. resulting in their inability to fulfill debt obligations. Foreigners accounted for an increasing proportion of SET’s turnover value. in the end.4).133 1. the averages for all three profitability ratios took a downswing all the way until 1996. 1993-1999 Item Number of Listed Companies Number of Listed Securities Market Capitalization (B billion) Turnover Value (B billion) SET Index a 1993 1994 1995 1996 1997 1998 1999 a 347 408 389 494 416 538 454 579 431 529 418 494 392 450 3.201 2.4 percent in 1996. The trend reversed in 1995.610 1. While the decline in gross profit margin was not as sharp. return on equity (ROE). But instead of shifting to a low gear. Side by side with this surge of financing for corporate growth.268 2.114 1.560 1.360 1. however. had been on the rise throughout the 1980s. The upward trends for ROE and ROA continued through 1989. The plunge in profitability and asset turnover—from 117 percent in 1985 to 65 percent in 1996 for the latter—cast doubts on the .1 by 1996. the companies could not generate enough net returns from their assets and equity.193 2. their share rising from 17 percent in 1993 to 43 percent in 1997.3 Statistical Highlights of the Stock Exchange of Thailand. its high point in 1995 at B3. Meanwhile. not all public companies are listed on the SET.5 at its peak in 1987. Throughout the 1990s. was the ominous deterioration in the key financial ratios of publicly listed companies. The key financial ratios of all companies listed on SET bear this out (Table 4. gross profit margin rose until 1991 before falling in 1992.301 3.683 1.565 2. the average times interest earned (TIE) was down to 5.281 832 373 356 482 Due to listing requirements and other reasons.4 percent to 5. ROA dipped from 10.6 trillion. ROE similarly fell from 21.8 percent. From 10. pulled down by active public offering activities. the highly liquid financial system continued offering cheap funds to sustain corporate sector investments.303 930 855 1.
was also distinct in the region.4 12.7 5. was felt across industries.6 12.2 10. but was most severe in building and furnishing material industries as a result of the downturn in the real estate market. US.2 27. Among the crisis-hit countries.0 29. Despite the availability of the equity market.7 59. Thailand’s ROE.4 24.4 26.9 7.7 LongTerm Debt to Asset Assets Turnover (%) (%) 14.4 7.2 10. They were generally more efficient in managing their assets and . the textiles.1 120.4 51. practice of heavy borrowing.5 63.2 35.7 20.8 8.6 27.7 12.4 12.3 4.4 Key Financial Ratios of Publicly Listed Companies.8 14.1 16.3 8.2 6.4 7. II Table 4.8 54.7 21.0 3.4 9. clothing.4 119.1 52.4 4.8 88.9 144.4 139.0 139. It has also been argued that family-based controlling shareholders borrowed excessively to avoid diluting their control over their corporations.5 38.2 10.8 25.7 12.5 50. and footwear had the lowest at 11 percent.9 8.4 44.238 Corporate Governance and Finance in East Asia.0 63.7 12. these companies opted for debt.6 125.1 114.7 12.9 7.9 51. Korea and Thailand had the highest debt-to-equity ratios.7 4.4 34.1 60.5 15.0 145.5 30.4 47. and footwear industries also experienced losses.2 64. clothing. large companies (where size is reckoned in terms of assets or sales) were more profitable than small companies in terms of ROE (Table 4.6 138.4 28.7 34.3 91.6 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. which fell from 16 percent in 1991 to just under 6 percent in 1996.9 77. A major reason for this was the rapid rise in asset prices. Severely affected by global competition throughout the decade.2 161. resulting in higher collateral values for borrowers.2 49. Hotels and travel showed the highest ROE of 15 percent while textiles.4 5.5 52.0 7.8 51.8 11.7 54.7 35.7 5. which was particularly significant in the two years preceding the crisis.9 27.7 27.7 15.7 80.8 5.6 36.8 5.2 27.5). Overall.5 9.0 125.6 168.2 215.3 10.9 14.7 27.8 151. 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 (%) (%) (%) 3.5 51.7 5. Vol.6 7.6 41.3 12.9 66.1 44.1 16.1 242. The downtrend in corporate profitability.0 117.4 3.4 18.9 140.1 9.9 39.
Although stable in the 1980s.5 94.6 5.4 Legal and Regulatory Framework Before 1992.6 30. Cumulative voting. However.8 62.3 135. There were also concerns that the provisions governing the criminal prosecution and penalties of directors and management were harsh and inappropriate.3 25. capital despite the higher gross margins of small companies.2 121.2 18.3 176.7 6. could lead to a high turnover in the board.1 25.2 12.6 30.0 48.9 13.7 14. the law disallowed cumulative voting.5 6.8 10.3 52.8 26.0 83. which would be disruptive to company management.6 6. measured by total asset turnover. For instance.4 8.1 29. it was thought. Increasingly heavy borrowings rendered the sector even more vulnerable to lower profitability and sales. During the 1990s. 4. some rules and regulations of this particular law were believed to be too restrictive and were discouraging companies from going public.4 52.6 61.1 Small Medium Large 5. weaknesses became evident.8 6.8 47.0 20.5 87.3 88.3 49.1 6. the overall activities of listed companies. total asset turnover declined after 1989.6 31.3 43.2 134.9 20.6 7.3 23.3 164.5 7.2 10.8 142. by the 1990s.7 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. They also tended to use more financial leverage than small companies as their total DERs show. 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 6.3 15. In sum.5 Average Key Financial Ratios by Company Size. although the performance of listed companies in the late 1980s was strong. US.2.1 13.4 116. .3 49.6 10. also deteriorated. The argument was that having a Board of Directors whose members represented different groups of investors would create conflicts and hamper management effectiveness.1 5. the Public Limited Company Act of 1978 and its amendments regulated Thai publicly listed companies.Chapter 4: Thailand 239 Table 4.7 10.8 6.6 12.
concentrated ownership. The legal and regulatory framework for the corporate sector also includes provisions related to insolvency. As it turned out. However. 2 ADB survey questionnaires were sent to all Thai listed companies in early 1999. The provision discouraged original family owners from registering their companies. The protection of minority shareholders was inadequate under the Public Company Act of 1992.2 The market for corporate control was not active and did not give managers strong incentives to perform efficiently. Cumulative voting was made optional. from holding more than 50 percent of total outstanding shares and other shareholders from holding more than 10 percent of outstanding shares individually. As the succeeding sections point out. the exit of these provisions appears to have contributed to the 1997 financial crisis. II Another issue was the proportion of shareholding by top shareholders. coupled with weak corporate governance. and the punishment for management misconduct was also lightened considerably. . This will be discussed in Section 4. An Asian Development Bank (ADB) survey conducted for this study shows. The Public Company Act of 1992. for instance.3 Corporate Ownership and Control Ownership and control of corporations in Thailand are highly concentrated. a feature that is believed to have impaired the effectiveness of existing regulatory mechanisms in the corporate sector. Fortysix companies responded. as a group. The original company owners welcomed the changes and the number of publicly listed companies subsequently rose to more than 600. played an important role in bringing about the financial crisis. adopted to promote the development of publicly listed companies.5. the new legislation removed a number of incentives that would have kept public companies prudent and diligent in their operations. and external monitoring and control of corporations were also weak. the limit on shareholdings by the largest shareholders was increased from 50 to 70 percent of total outstanding shares.240 Corporate Governance and Finance in East Asia. but not all questions were answered. 4. The law prohibited the largest shareholders. relaxed the contentious provisions of the 1978 Public Limited Company Act. that creditors had generally little influence on the management of corporations. Vol.
9 4.3 7.4 5.4 6.5 Average for 1990-1998 period.8 11.Chapter 4: Thailand 241 4.7 7. China firms have the highest single shareholder ownership concentration at 35.9 54. 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. Ownership Concentration Between 1990 and 1998.9 55.1 3. Source: Comprehensive Listed Company Information Database.2 4.1 4. on average.4 6.7 6.0 7. But with their increased reliance on new varieties of equity and debt instruments. there were only slight variations in the pattern.3 16. In the past. . Unfortunately.7 percent.7 12.3 percent and 18. and Hong Kong.2 4. and 28. Across industries. Indonesian.9 6.5 9.3. with the largest shareholder on average controlling 10. respectively.3 percent.0 5.3 7.4 4.1 5.0 3. Ownership was most concentrated in the packaging.0 3.2 11. creditors.0 56.2 4.9 3.6 28.6). these companies obtained funding solely from banks or from their own retained earnings.6 68.4 26.4 26.6 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand. this was not the case.4 percent of outstanding shares.3 5.6 27.3 28.9 52.9 percent of shares of a company. Most large Thai corporations listed on SET started out as family businesses.6 4. Stock Exchange of Thailand.0 53.1 5.2 56.6 57.4 26.9 3. and minority shareholders to stake their claim in the control and regulation of these companies.9 11.1 5. 56.8 32. 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 28.1 percent of control rights.China have the least concentrated ownership.9 52.7 11.9 26. with the top three shareholders accounting for almost 50 percent (Table 4.4 10.1 11. one would expect the public. Thai.1 12.3 11. 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. In contrast. Table 4.0 7. This implies that the top five shareholders enjoyed full control over the outcomes of shareholder meetings.9 52.8 5.1 7.5 28. 33.
and building and furnishing industries.034*** 0. 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 4.169*** 0. US.800 0.7 Statistical Relationships between Corporate Profitability.029 3. II agribusiness. Through these holding companies.7).001 0.090 0.116) Debt-to-Equity (1.072) (0. Table 4.022*** 0. with a top-five ownership concentration of at least 60 percent. including those that are publicly listed . Based on a regression analysis. Source: Author’s estimation based on the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.003 0. owning 26.031 3. It is the practice of Thai corporate founding families to set up holding companies to own shares in affiliated companies or subsidiaries.080 6. Leverage. Vol. and ownership types. *** at the 1 percent level. results show a significant positive relationship between ownership concentration and financial leverage.001*** 0.058* ROE (0.001) 0.115 9.7 percent of outstanding shares on average (Table 4.8). These are consistent with the hypothesis that companies with more concentrated ownership tend to engage in higher debt financing because their controlling owners do not want to dilute their control by bringing in new equity holders. and Company Size Item Intercept Top Five Ownership Concentration Company Size Adjusted R-Squared F-Statistic ROA 0.005** 0. Composition of Controlling Shareholders Affiliated corporations comprise the largest group among the top five shareholders of publicly listed companies. ** at the 5 percent level.533)*** Debt-to-Assets (0. Other industries had their top five shareholders controlling at least 55 percent of outstanding shares. founding families maintain effective control of entire groups. * Denotes significance at the 10 percent level. year. as measured by debt-to-equity and debt-to-asset ratios.037 0.242 Corporate Governance and Finance in East Asia.647 Note: The regression included dummy variables for industry. Company size is significantly related to ROE and leverage. On the other hand. Ownership Concentration.
3 — = not available.3 27.9 7.2 18.8 1.7 Bank 2. unlike in Japan where crossshareholding is common.3 1.7 0.6 1.6 5. Typically.5 1.3 27.5 26.0 3.7 — 1. the company increased its registered capital and became a public company listed in SET.3 0. This practice is illustrated by Central Pattana. the company. Individual family members also hold a significant amount of outstanding shares.5 NBFIsa 6. individual members of the Chirathivat family aggregately hold 25.5 percent. The ADB survey indicated that listed companies held shares in an average of 11 companies. Source: Comprehensive Listed Company Information Database.1 0. In 1994.9 15. the affiliate firms rarely hold shares of their parent companies.6 1.4 1. operates five of the most successful shopping malls in Thailand.7 1.3 1. Established in 1980 with a registered capital of B300 million. Stock Exchange of Thailand.3 27.8 0.8 28. The largest shareholder is Central Holdings Company.5 5. in SET. including finance and investment companies.9 0.9 18. 1990-1998 Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 Average Company 28. The roster of its major shareholders as of December 1997 illustrates the typical ownership concentration of a publicly listed company in Thailand.9 19.1 1.7 5.4 20. Although holding companies set up affiliate firms.6 28.8 23.2 7.0 17.5 0.3 20.4 1.9 6.2 5. a NBFIs denotes nonbank financial institutions. owned by the Chirathivat family.2 1. In addition.6 1. .5 Government Other 0.5 1.6 percent of outstanding shares. The top 10 shareholders include a holding company owned by the Tejapaibul family.5 2.5 Individuals 13. a company listed in the real estate sector of SET.6 25.5 0.4 1.0 18.2 1. founding families and their relatives maintain control of many companies by jointly holding on to the most significant chunk of shares. one of the founding members. These individuals usually hold important management positions in concerned companies.1 4.0 19. averaging about 18.8 Top-Five Shareholder Composition of Publicly Listed Companies in Thailand. a joint venture among three families.3 1.3 percent of outstanding shares. with 29.4 22.1 1.Chapter 4: Thailand 243 Table 4.5 0.
Moreover. holdings by individual family members and holding companies account for at least 50 percent of outstanding shares of an average listed company. both conducted in 1999. they account for 80 percent of total outstanding shares. 3 Discussions in this section are based on results of company surveys by SET and ADB. these shareholders are able to control the company. and responsibilities of directors of public companies. Although the list of top shareholders of publicly listed companies includes financial institutions. Another example is Bangchak Petroleum Plc.9 percent of outstanding shares. Except in the hotel and travel service sector.5 percent of total outstanding shares. 1. has the Ministry of Finance as its only large shareholder with 92. the Petroleum Authority of Thailand. commercial banks account for only 1. The Government holds. with the envisioned privatization master plan. only one tenth of listed companies have commercial banks on their top-five shareholder list. . II another of the company’s founding members. 4. There was a trend of rising government shareholdings throughout the period 1990 to 1998. duties. Thai Airways International Plc.3. and a state bank. Across industries. For example. the Government’s role in public companies is expected to decline. However. About half of listed companies have nonbank financial institutions such as finance and investment companies in their top-five shareholder list. Only a handful of companies have the Government among their large shareholders. where the top three shareholders are the Ministry of Finance.1 percent of total outstanding shares of listed companies.2 Corporate Management and Control3 Board of Directors The Public Company Act of 1992 stipulates the appointment process. In such cases. In effect. the top 10 shareholders consist predominantly of members of founding families and their holding companies.5 percent of total outstanding shares of listed companies. Nonbank financial institutions hold an aggregate 5. qualification. Together. the Government owns the majority of the shares. the predominance of individual family members and holding companies in the top shareholder list remains valid. roles. they exercise limited influence in operations because of the restricted size of their shareholdings.. Vol. By owning 62 percent of voting shares. on average.244 Corporate Governance and Finance in East Asia. On average.
Meanwhile. meanwhile. Three companies indicated that the CEO and the chair were close relatives. If found in violation of these provisions. Some companies (36 percent) had five to six main board members holding seats in their executive boards. Generally. The appointment of the chief executive officer (CEO) needed approval during the AGSM in 11 of the responding companies. Most companies (83 percent) satisfied SET’s requirement of having two independent board members. Although 28 percent of the chairpersons came from the ranks of independent outside directors. Unless stipulated in public companies’ articles of association. 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. directors may be imprisoned or fined. In addition. The ADB survey indicated. In five other companies. In their business conduct. and to comply with the laws and articles of association. an executive board consists of senior management and some main board members. Almost all companies (98 percent) exceeded the minimum required five members in their Board of Directors. while 15 percent of respondents went beyond the requirement. while 30 percent of respondent companies held board meetings monthly. that only in two of the 46 responding companies were the chair of the boards elected based on the extent of their shareholdings. 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. but not in 22 others. Nineteen companies stated that selection was based on professional qualifications. A survey by SET found that the majority (58 percent) of the 202 responding companies held their board meetings every quarter.Chapter 4: Thailand 245 Directors are required to meet minimum qualifications specified under the SEA of 1992 and the Listing Rules issued by SET. selection was based on relationships with controlling shareholders. directors shall be elected at the annual general shareholders’ meetings (AGSMs). the majority (71 percent) had board chairs who were also members of top management teams. Many companies have a formal policy on corporate governance and business ethics. directors could be compelled to compensate the company for damages arising from their misconduct. .
Fourteen other companies had profit-related incentive schemes in addition to fixed fees. these were attributed to variations in the extent of duties and responsibilities assumed by those directors. The ADB survey indicated that 18 of the 46 responding companies compensated their chairpersons using a fixed-fee schedule. These committees were mainly responsible for determining compensation for senior and regular staff. Audit Committees and Accounting Standards Since January 1999. while 19 companies observed only some of them. However. The SET survey found that the majority of listed companies (81 percent) still have no separate audit committee. not an independent assignment. Half of the companies in the SET survey had a separate remuneration committee. Twenty-five of the 46 respondents to the ADB survey declared adherence to all relevant international standards. Directors with managerial responsibility or those related to major shareholders cannot be members of such audit committees. the majority of the companies (77 percent) did not have outside directors as members of their remuneration committees. 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. 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. the remuneration packages had to be approved during AGSMs. Where different.246 Corporate Governance and Finance in East Asia. all listed companies have been instructed to establish audit committees to be responsible for examining the quality and reliability of company financial statements. Companies already with audit committees did not have independent outside directors as audit committee members. Also. the auditor is not . with 41 firms admitting the use of services of international auditing firms. Chair. All respondents confirmed the use of external auditors. the work of this committee was often considered part of the executive board’s responsibilities. however. In 25 companies. and CEO The majority of company respondents to the SET survey provided similar compensation packages to internal and external directors. II Compensation of Directors. Three companies allowed their management to determine the chair’s compensation package. Vol.
averaging about 14 years. SET. shareholders can claim compensation in cases of negligence or dishonesty by management. The majority of the companies (85 percent) require the appointment of external auditors during annual general meetings. the corporate sector lacks a strong self-regulatory body to compel compliance with these standards. including false statements to conceal information about the financial condition and operations of the company during the sale of shares. although recently. debentures. likewise. shareholders have access to reliable information at no cost. The Act also holds directors liable for any damage to shareholders. Shareholders are also entitled to call emergency meetings and present proposals at AGSMs. (iv) The roles and responsibilities of the major government agencies regulating shareholder rights—the Ministry of Commerce. Proxy solicitation tends to be abused to the extent that shareholders are inadequately informed about matters to be taken up in shareholder assemblies. (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. SET’s rules and regulations closely follow this Act. Forty-four companies indicated that they had proxy voting in place. most responding companies have rules and regulations intended to protect shareholders. According to the ADB survey. or other financial instruments. For instance. In the majority of these companies (38 out of 46 respondents). 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. stipulates the proper conduct of shareholder meetings. Relationships between firms and external auditors are generally long-term. remuneration. as well as the registration and holding of shares. As a result. SEC. and executive committees. and the Bank of Thailand— are not clearly defined. At least 28 responding companies had the following . the institutional machinery is not fully responsive to complaints about violation of shareholder rights. the Securities and Exchange Commission (SEC) and SET were actively prosecuting violating firms. there are also significant gaps in the system of shareholder protection. However. While safeguards are in place. (i) No standards are enforced in the content and timing of notices for shareholder meetings. The Act.Chapter 4: Thailand 247 independent from the company. with 13 companies allowing proxy voting through mail.
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.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. it would be difficult for minority shareholders to gather the shares needed to take action. Only a small number of shareholders attended the latest AGSMs. takeover of the company. 66 percent of total outstanding shares.3. they comprised only 8 percent of total shareholders. the only group of shareholders that can exercise rights is the top five shareholders. and insider trading. II mechanisms in place: mandatory shareholder approval of major transactions and interested or related party transactions. minority shareholders may also appoint an outside inspector to examine the company’s operations and financial condition. . 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. given their importance in providing finance and their stake in companies. In practice. did not vote in previous AGSMs. The ADB survey results reveal that the proposals presented by management were rarely rejected during the general meetings. The difficulty minority shareholders have in exercising their rights can be seen from the ADB survey results. In theory. and call an extraordinary session. On paper. and mandatory disclosure of related interests and significant shareholders’ transactions. The SEA of 1992 and the listing rules also contain provisions for the protection of shareholders against transfer pricing. While stimulating the growth of the sector. the new Public Company Act of 1992 inadvertently weakened the governance of public companies by diminishing minority shareholder rights. Vol. however.248 Corporate Governance and Finance in East Asia. Banks would be obvious candidates to implement these mechanisms. Almost 82 percent of shareholders. minority shareholders are assured adequate legal protection. But the exercise of these rights requires even higher shareholding levels. representing only about 28 percent of shareholdings. In effect. such protection has been insufficient. on average. 4. Although the attendees held.
Fifteen of the 20 companies that had to renegotiate loan repayment with creditors in the last five years did so after the crisis.Chapter 4: Thailand 249 Historically. Most companies reported that banks were more likely to require collateral. Under a weak bankruptcy system. For 20 of the 46 responding companies. The presence of collateral usually diminishes banks’ incentives for screening project feasibility and monitoring project implementation. creditors’ collateral requirements were tightened after the crisis. Eleven companies stated that creditors usually exercised whatever influence they had on management through covenants regarding the use of loans. when insiders want to expand their company’s operations without losing control. other than losing control. Debtors had many handles to stall the bankruptcy process. to solve debt repayment problems. while loans for fixed investment were also more likely to be supported by collateral. Apparently. There were many options. . One tempering mechanism that could inhibit the excessive use of borrowing is the threat of losing control in the event of bankruptcy. The impact of the financial crisis on credit eligibility and supervision requirements has been significant. Only three companies thought otherwise. as the ADB survey confirmed. Actual bankruptcy proceedings took more than five years on average. which could cause a delay by at least a year. However. while 18 said none of their creditors required collateral. creditors do not always require project feasibility studies or business plans in granting loans. Leverage allows the assets and operations of the company to grow without diluting corporate control. they resort to borrowing. 11 experienced rejection after the crisis started. Only 28 of the responding companies in the ADB survey indicated that their creditors required such feasibility studies. such as that seen in Thailand before the crisis. the majority believed that creditors had little influence on company management and decision making. Thailand has relied on commercial banks and finance companies to channel funds to private enterprises. however. Among 16 companies in the ADB survey whose loan applications in the last three years were rejected. In the end. The old bankruptcy law in Thailand also made it difficult for creditors to obtain payment against bankrupt borrowers. including procedural disputes. 17 indicated that only some of their creditors had such a requirement. borrowers seldom lose control to creditors even when they default and become insolvent. a company’s reputation and its long-term relationship with creditors sufficed in many instances. Normally. Seven of the companies responding to the ADB survey indicated that all their creditors required collateral.
SEC has no authority to either approve or reject tender offers. if the purchase of shares implies a change in the directors or business activities. whether directly or indirectly. Although merger and acquisi- . Since the introduction of the Public Limited Company Act of 1978. with a total tender offer value of B42. The Market for Corporate Control The SEA of 1992 was the first legislation that stipulated rules and regulations regarding the market for corporate control. which is a general offer made to shareholders of a company to acquire at least 25 percent of outstanding shares. the minimum tender offer was reduced to 10 percent and some procedural modifications have also been introduced.9). Recently. (ii) an advertisement regarding the tender offer must be placed in major newspapers for at least three consecutive days. only a limited number of successful mergers of public companies have taken place. SEC was later made responsible for regulating corporate takeovers. its main role is to ensure transparency and fairness. The situation remained sluggish in 1997 at nine tender offers and a further decline in total offered value. II The financial crisis has presented a unique opportunity for reinventing the framework for corporate bankruptcy and for creating regulatory and judicial precedents. It will take years.250 Corporate Governance and Finance in East Asia. 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 company has 21 days to evaluate the tender offer and submit a report to SEC and all shareholders. before the extent to which the bankruptcy framework has been strengthened becomes clear. According to the SEA of 1992. of shareholders: (i) all shareholders must receive tender offers. a person who acquires more than 5 percent of issued shares must file a report with SEC one day after the date of acquisition. In 1994 and 1995. The market for corporate control has not been active in Thailand. In 1996.3 billion. and (iii) tender offers will be effective 30 days after the report has been filed with the SEC.3 billion (Table 4. The first category is the acquisition of shares in the open market. The second category is the tender offer. There are detailed requirements regarding such notification. however. In this case. with a significantly lower total tender offer value of B8. Such efforts would serve to strengthen external discipline on controlling owners. there were only six tender offers. there are two categories of merger and acquisition activities with associated regulatory measures. there were 41 cases of tender offers. and failed to provide managers with strong incentives to perform efficiently. Vol.
Pension funds are perhaps even weaker in Thailand.8 81. While the Thai mutual fund industry compares well to those in other developing countries in the region. Even when companies offer ESOPs. 1993-1999 Year 1993 1994 1995 1996 1997 1998 1999 a Tender Offer Valuea (B billion) 5. they have mostly been concerned with short-term gains. tion activities increased after 1997. employee participation in corporate governance in Thailand. employees are even less willing to accept common shares as a form of compensation or benefit.5 6. Twenty-nine firms indicated that employees held shares of their companies.9 Merger and Acquisition Activities.6 17. .7 Purchase Value Number of % of Tender Offer Value Companies 84.2 6.9 3.1 58.2 7. but employees have never been represented in the board of directors since their shareholdings are minimal.1 75. if any. Because of the current crisis. it remains small. Source: Securities and Exchange Commission of Thailand. Employee Participation in Corporate Governance There has been little.0 B billion 4. most of these were forced mergers or related to rescue packages.1 84.Chapter 4: Thailand 251 Table 4. The number of domestic institutional investors rose after the mutual fund industry was established in 1991. But instead of opting for an active role in the market for corporate control.3 60. trading by mutual funds in SET represented less than 10 percent of total trading.4 23.8 8 27 14 6 9 13 23 Tender offer value refers to the minimum offer value. Few companies offer employee stock option plans (ESOPs).3 6. but the average shareholding is smaller than 1 percent of total outstanding shares.3 11.7 11.1 19. Provident funds for government workers and workers in public enterprises have been established only recently.2 8. employees regard the plans as monetary incentives. Since 1994. Eleven of the 46 responding companies in the ADB survey offer ESOPs.2 6. not with a view to becoming involved in actual management.0 55.
3 1.372.5 Outstanding Loans from Commercial Banks 2.0 424.0 8.8 3. the banking sector was highly concentrated.4 519.193.0 3.300.477.6 2.2 262.037.1 5.559. .775.1 6.669.5 4.6 6. accounted for 28 percent of the banking sector’s total assets.. II 4. Many large commercial banks had affiliates among the 93 finance companies that served the high-risk market. Competition from foreign banks was limited as they were not allowed to engage in full branch operations.5 5.4 1.3 546.4 Year 1992 1993 1994 1995 1996 1997 1998 1999 Source: Stock Exchange of Thailand. The country’s largest bank.119. The total values of loans from financial institutions and commercial banks were consistently larger than the market capitalization of SET.906.5 trillion. although its role increased in the wake of the crisis.485.8 941.1 Corporate Financing Overview of the Financial Sector A breakdown of the Thai financial sector for the period 1992-1999 (Table 4.10) shows that Thailand is a highly bank-dependent economy. and Bank of Thailand.252 Corporate Governance and Finance in East Asia. The share of domestic banks in the banking system’s total assets was 80 percent. In 1996. Bangkok Bank Ltd. Thai Bond Dealing Centre.325.10 Size and Composition of the Thai Financial Sector.3 5.564. 1992-1999 (B billion) Outstanding Loans from All Financial Institutions 2.268. The bond market played only a marginal role in corporate financing.6 1.4 3. the next four largest banks accounted for 63 percent.0 339.1 3.5 4. The Banking System Until recently.5 6.171.912.1 7.430. total assets of commercial banks amounted to B5.4.2 2.0 SET Market Capitalization 1. there were 29 commercial banks. 15 of which were domestic banks. Table 4.663.979.1 Domestic Debt Securities Outstanding 215.230.390.4 4.825. Vol.360.4 4.1 3.9 2.161.133.
the stock market entered its first boom period in 1986. The number of listed companies also quadrupled between 1981 and 1993. The lack of supply of quality shares was a big problem for SET at that time. Licenses were granted to 15 Thai banks. Through the years.Chapter 4: Thailand 253 The Government was also a major figure in the banking system. the market rose steadily and reached a record high in the fourth quarter of 1993. the SET index declined. In the following years. BIBF banks also enjoyed tax incentives on their operations and profits. due to their close ties. and property have accounted for the bulk of trading volumes. The Government removed controls on capital and dividend repatriation in 1991. After that. reaching 355. Banks under the BIBF scheme were allowed to mobilize funds from abroad and lend to Thai companies in foreign currency. Despite the worldwide market crash in 1987. Stock prices tripled in the next three years until the market experienced its first crash as a result of the Gulf Crisis in 1990. In 1993.2 trillion. also made it unattractive to raise capital from the equity market. The Equity Market During the first few years of its operations. 12 existing foreign banks. finance. an over-the-counter market. In contrast. Some 347 companies were listed in the same year with a total market capitalization of B3. SET immediately recovered due to the strength of the Thai economy. and 20 new foreign banks. Easy access to commercial bank loans by family business groups. banking. Banking activity peaked in the mid-1990s. the Government established the BIBF to expand the banking sector and reduce the borrowing costs of Thai companies. and almost all capital account transactions were deregulated. SET was not very active. Benefiting from rapid economic and industrial growth.8 in 1998. owning 70 percent of the country’s second largest bank. was set up by 74 members with an initial capital of B500 million. Turnover value reached B2.3 trillion. Because borrowers carried the exchange rate risk. the liberalization of interest rates and capital account transactions stimulated a credit expansion through short-term borrowings in foreign currency. BSDC is a nonprofit. Many company founders did not want to release even a small portion of corporate ownership and refused to go public. hardly any progress was made in lowering the cost of domestic financial intermediation or in developing new financial instruments for corporations. the Bangkok Stock Dealing Center (BSDC). self-regulatory organization under the . SET is organized into 32 major industries. In 1995.
securities deposit center. The company should then appoint a financial adviser. securities can be traded in the secondary markets. which consist of SET and BSDC. II jurisdiction of SEC. turnover value was negligible and the BSDC Index remained flat throughout 19961998. stock trading can commence within five days. . the two classifications were merged. each holding no more than 0. Authorized companies were those with a minimum of 200 shareholders owning collectively at least 25 percent of paid-up capital. The primary market is supervised by SEC. Its main role is to serve as a secondary market for unlisted companies trying to raise capital. SET established new requirements for initial public offerings. A company wishing to qualify for listing in SET must file an information booklet (prospectus) with SEC and SET. Proposed changes in capital must be submitted for approval to SET accompanied by a detailed memorandum outlining the use of proceeds. Company applicants must have an established history of operating under substantially the same management. Listed companies were those that had (i) paid-up capital of at least B20 million.8 billion in 1996. According to the SEA of 1992. After initial public offerings. so now only listed companies are traded in SET. also acts as a clearinghouse. among other functions approved by SEC. to assist in the public offering process. and securities registrar. Before 1993. The allocation procedure is nondiscretionary. If the issue is oversubscribed. 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. with each facing different listing requirements.254 Corporate Governance and Finance in East Asia.5 percent and collectively owning at least 30 percent of paidup capital. SET. Only one security was listed in BSDC in 1995 and two more in 1996. there were two kinds of companies in SET—“listed” and “authorized” companies. If approved by SEC and the SET Board of Governors. The listing application should be submitted concurrently to SEC and SET. It separated the primary and secondary markets to promote more flexible and effective supervision of both. Vol. and pro forma balance sheet and income statements. lottery drawing must be used to ensure fairness. In July 1990. approved by SET. The SEA of 1992 installed the legal and regulatory framework for Thai capital markets. but dropped the following year to B122 million. Consequently. however. Turnover value was B1. the BSDC was dissolved in 1999. 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. and (ii) a minimum of 300 shareholders. In 1996. financial projections.
. the Government issued more bonds to finance industrial development projects and perennial deficits. Beginning 1961. was also instrumental to the growth of the corporate debt market. 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. Investors had limited knowledge of debt instruments. Companies generally issued short-term debt instruments like promissory notes or bills of exchange. it represented only 9 percent of GDP. A turning point of the corporate debt market was the enactment of the SEA of 1992. The bond market in Thailand started in 1933. Four years after the passage of the SEA. it accounted for a small share of the entire financial sector. However. In 1996. The Thai bond market was also smaller than that of Malaysia (56 percent of GDP) and the Philippines (39 percent of GDP) in that year. the year the Ministry of Finance first issued government bonds to finance infrastructure projects and economic development.11). 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. To gain some perspective of the size of the bond market in Thailand. the Bank of Thailand assumed responsibility for regulating the bond market. The recent financial crisis. the first bond rating agency in Thailand. compared to 110 percent in the US and 74 percent in Japan in the same year. the size of the corporate debt market rose to B132.9 billion. while secured debt instruments accounted for just above 10 percent. which encouraged limited companies and public companies to issue debt instruments. The proportion of domestic convertible debt instruments increased until 1995. at about 11 percent of the total value of outstanding loans extended by commercial banks and 20 percent of total equity market capitalization. in 1994. and the Government did not issue new bonds during 1990-1997. The budget surpluses of the 1990s eliminated the need for new bond issuance. The Thai Rating Information Services. led to the renewed issuance of Government bonds to finance the resurgent budget deficit and support cash-strapped financial institutions. however. State-owned enterprises became active issuers of bonds since 1993 because the Government constrained their borrowings (Table 4. A breakdown of domestic offerings of corporate debt securities from 1992 to 1996 shows that unsecured debts accounted for about 60 percent. Upon its founding in 1942.Chapter 4: Thailand 255 The Bond Market The Thai bond market has played a marginal role in corporate financing until recently.
By 1995.7 95.9 40.8 55.5 55.2 39.5 5.0 60.0 33.7 132.2 43. The decline in total domestic debt offerings in 1996 can be ascribed to the increase in offshore convertible debts. BDC was established in November 1994 by 50 securities companies based on the provisions of the SEA of 1992.9 37.0 281.1 21. the year the crisis unraveled and the baht was floated. The following year.7 28.3 13. total offshore debt offerings had plunged by 68 percent to a mere B28.1 12.2 28.7 90.0 86.0 — 26. A sharp rise in unsecured offshore debt offerings can be noted all the way through 1996.1 121.5 — — 32.4 — 9.5 billion.0 0.6 billion.9 37.0 — 5.4 — — — 1.5 — — — — 1.7 — — 40.2 57. turnover value had reached B51. Vol.2 45.8 2.8 47.4 billion.3 8.0 333.1 107.7 7.5 10.1 55. II Table 4.6 19.5 — — — 3.3 46. Total offshore debt offerings peaked in the run-up to the financial crisis.4 7.3 — — 3.3 50.1 — — — 29.7 821.3 6.7 538. 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 — — — — — — 400.4 49.1 59.0 26. The club was considered the first organized secondary bond market in Thailand to serve as the wholesale market for debt securities.1 8.1 315.7 — — — — — 4.5 138.256 Corporate Governance and Finance in East Asia.1 41.4 110.7 0.6 — — 0.1 6.1 10.9 329.1 61.2 — — 50.7 5. by the end of 1997.5 — 39.1 — — 6.8 167.5 43.0 17.1 289.5 — 0. .5 37. then declined substantially in 1996 and 1997.3 140.0 5.3 46.11 Offerings of Debt Securities.7 5. 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.8 191.7 — — — — — — — 77.2 89.7 0.0 27.3 22.3 — 14.9 30.8 Source: Securities and Exchange Commission of Thailand and the Thai Bond Dealing Centre. this had climbed to B200.1 141.6 — 0.0 7.3 29.8 31.9 5.9 20.9 0.4 57. However.0 — 5.3 3.2 2.4 — 26.
Across industries. Construction and property development industries tended to have high proportions of long-term loans and debentures. From 1990 to 1996. For the construction industry. Retained earnings accounted for about 30 percent of total equity financing. and marketable securities holdings. Thailand’s publicly listed companies rely mainly on loans from commercial banks and financial institutions to finance their growth.2 billion as a result of the default of debentures due to the Asian crisis. a trend most apparent in the leap between 1991 and 1992. turnover value plummeted to B106. In the same year. Longterm loans accounted for about 20 percent of total liabilities.4. significant variations can be noted. 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. listed companies experienced liquidity problems with declining reserves of cash and marketable securities during the period 1990 to 1996 (Table 4. In addition.1 billion in 1998.12). Turnover fell further to B72. short-term loans accounted for more than 40 percent of total liabilities. The overall trend is consistent with the decline in profitability observed in the analysis of corporate sector performance earlier. with equity levels remaining high despite an increase in debt. the use of debentures remains minimal even though the trend was generally upward until the 1997 crisis. The closure of 58 finance companies affected the BDC significantly since half of its members were suspended as a result.Chapter 4: Thailand 257 compared with investment in equities. overall asset quality and liquidity of listed Thai companies deteriorated throughout the period. The ratio of net working capital to total assets decreased from a peak of 31 percent in 1993 to 28 percent in 1996. In any case. At lower than 5 percent of total liabilities. The average for all industries was only 22 percent. There was also little change in the trend in retained earnings within the seven-year period. steadily easing up between 1990 and 1996. In 1997. these comprised 31 percent. Companies in construction and property development seemed unable to generate internal funds. The proportion of accounts receivable also declined steadily. Equity financing remains an important part of listed companies’ long-term financing. while for the property development industry.2 Patterns of Corporate Financing An examination of financing patterns among Thai companies listed in SET shows that on the asset side. 4. these accounted for 33 percent of total liabilities. they also had a relatively small proportion of equity and . cash balances.
3 6.8 25.7 9.5 9.2 1.6 0.0 100.9 14.0 7.8 1.6 8.6 50.6 15.3 50.6 38.0 100.3 21.8 17.2 22.0 100. US.1 36.3 2.1 17.12 Common-Size Statements for Companies Listed in SET.8 14.2 16.2 2.0 Assets Cash Marketable Securities Accounts Receivable Inventories Other Current Assets Total Current Assets Net Fixed Assets Other Assets Total Assets Liabilities and Equity Accounts Payable Short-Term Loans Other Current Liabilities Total Current Liabilities Long-Term Loans Debentures Other Liabilities Total Liabilities Capital Stock Paid-In Capital Retained Earnings Total Equity Total Liabilities and Equity Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.9 14.13).7 1.9 17.6 100.7 52.9 38.0 10.8 8.0 1.2 45.0 100.1 18.3 18.6 13.0 100.4 49.6 0.2 12.8 7. and low) also underscores that companies with high ownership concentration had high levels of long-term loans (Table 4.7 50. The agribusiness industry relied more heavily on short-term loans at 56 percent of the industry’s total liabilities.5 1.3 1.9 15.8 46.3 18.5 0.0 100.0 100.2 17.4 49.9 14.7 18.9 14.5 43.0 2.258 Corporate Governance and Finance in East Asia.4 2.2 3.0 15.6 11.9 6.9 6. medium.0 12.6 51.6 18.0 51.0 100.9 17.8 10.0 100.3 34.4 21.0 100.0 100.3 49.4 17.7 0.3 1.2 16.3 25.8 9.0 13.2 2.6 12.6 100.6 22. Printing and publishing companies had lower financial leverage than companies in other industries.6 14.3 14.9 2.7 36.0 10.0 6.1 13.1 7.2 1.9 14.5 1.7 16.4 17.3 17.4 48.2 2.4 14.8 6.6 0.3 14.0 100.4 8. Analysis of common-size statements by ownership concentration (based on the levels of top-five ownership concentration classified as high.9 0.2 43.2 15.2 17.9 16.8 34. The level of total liabilities for the group characterized by high ownership concentration .9 43.4 43.3 38.2 17.5 11.9 12.7 7.6 21. 1990-1996 (percent) Item All Years 1990 1991 1992 1993 1994 1995 1996 2. compared with the 44 percent general average.5 14.0 48.9 3.8 20.8 37.9 49.7 14.1 49.8 9.0 100.2 1.8 35.9 18.0 14.5 9. II Table 4.6 0.0 100.2 42.1 50.2 2.1 2.8 19.7 17.2 43.6 2.9 20.6 10.9 50.8 37.9 40.4 7.9 10. were highly leveraged.1 5.3 48.8 3.7 16.5 1. Vol.2 35.2 34.6 6.5 37.4 6.2 17.8 21.3 34.7 15.6 36.3 12.
0 100.0 16.6 100.7 percent for medium ownership concentration companies and 49.9 2.4 18.1 44. common equity accounted for a smaller proportion of total assets (47 percent) than companies with lower ownership concentration. This is consistent with the observation that majority shareholders try to maintain their control by utilizing debt as a major source of funds.1 49.0 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.6 47.4 1.0 14.6 9.0 Low 1.0 41.8 12.7 17.5 100.1 18.4 3.2 11.6 14.6 15. Companies with medium ownership concentration tended to have a higher proportion of short-term loans.3 8.0 19.2 45.8 13.5 13. was 53 percent of total assets compared with 49.2 0.4 37.7 12.4 13.2 14.3 35.5 percent for low ownership concentration companies.8 13.3 1.3 100.0 6.2 8.3 1.9 16. 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 2.1 36.9 0.9 100.6 2.1 53. .9 50.6 22.9 7.4 7.9 21.0 7. For the high ownership concentration group.4 49.7 19.2 22.0 Medium 2.3 16.Chapter 4: Thailand 259 Table 4.0 6.6 0.13 Common-Size Statements of Public Companies by Ownership Concentration.4 35.5 11.4 50.5 18.5 21.9 36.0 100. US.8 37.
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. was the headlong deterioration of firms’ ability to meet their interest payment obligations. The financing patterns indicate that companies with high ownership concentration were more highly leveraged than companies with medium and low concentration. and rights issues. . and maintenance of the existing ownership structure.7 in 1994 to 5.7 34.7 34.8 5.2 68.1 64.1 23. however. thus rendering them more vulnerable. While further detailed investigations are necessary.3 31. More important.1 in 1996. The ratio of total debt to total assets increased from 50.7 11. however.8 151.4 5.0 25.6 7. The TIE ratio declined from its peak of 7.2 49.0 50.8 65.260 Corporate Governance and Finance in East Asia. Generally.0 28.0 145.5 38.8 51.7 12.4 44. US. As a result.6 138.1 16. Public companies relied more on short-term debt financing in the period before the financial crisis.6 125. followed by bank loans.1 31.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.9 63.8 65. Vol. The direct relationship between the degree of leverage and the degree of ownership concentration is apparent in Table 4. bond issues.9 14.7 percent in 1996.15.9 7.14 Financial Ratios of All Listed Firms.7 12. II Results from the ADB survey reveal that Thai companies preferred to use reserves and retained earnings as their first choice of financing.4 7.1 16.1 31.7 5. After the crisis.4 51.1 144.9 51. it would seem that firms with concentrated ownership and associated links to the banking system have easier access to debt financing. these firms more easily increased their leverage.8 percent in 1990 to 52. Short-term debt accounted for most of the increase.7 66. Table 4. especially from 1994 to 1996. Such deterioration of financial positions during the period was a common feature of listed companies.4 12.5 52.14).7 28.9 140.1 44. bond issues overtook loans from commercial banks as the second preference. 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. minimization of transaction and interest costs.6 41.4 139.1 52. the choice of financing is determined by the company’s liquidity considerations.2 35.3 61.
8 49. The proportion of nondebt-creating capital flows.16).9 percent in 1997. debt-creating capital inflows rose to 65 percent in 1990. 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.2 49.1 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. . The composition and term-structure of this debt.15 Financial Ratios of Listed Companies by Ownership Concentration.8 29.3 42.5 34.Chapter 4: Thailand 261 Table 4. is even more telling. the proportion of short-term debt increased from 15.8 28. Nonbank private debt increased from 27. on the other hand.6 11.0 64. private debt accounted for 84. such as direct equity and portfolio investment. however. The proportion of external debt as a percentage of GDP consequently increased from 42.4 27.5 percent between 1985 and 1990 to 8.4 percent to 46 percent during the same period.8 percent in 1986 to 52 percent in 1995.5.4 63.5 126. unhedged foreign exchange liabilities. From only 34 percent in 1986.8 14.4 13.8 Medium 7. This decline was accompanied.2 124. US.1 High 6. Their average annual growth rate declined from 28.5 percent of external debt in 1996 (Table 4.5 4.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. continued to slide from 1985 to 1997. Additionally. peaking in 1994 at 84 percent.6 30. 4.8 66. 1990-1996 Degree of Ownership Concentration Ratio Times Interest Earned Total Debt to Equity (%) Long-Term Debt to Equity (%) Total Debt-to-Assets (%) Long-Term Debt-to-Assets (%) Net Working Capital-to-Assets (%) Operating Capital-to-Assets (%) Low 6. The corporate sector contributed significantly to the crisis because of its rising levels of leverage. From 45 percent of total net capital movements in 1985.4 52.2 percent in 1986 to 251.5 148.7 percent from 1991 to 1996. and a preponderance of short-term debt liabilities.
0 11.9 6.8 10.7 0.9 29.9 3.Table 4.6 Total 18.9 1.3 12.4 5.5 19.3 105.3 — — — — — — — 6.5 1.4 10.6 52.2 14.16 External Debt.7 20.8 12.9 31.9 43.7 23.0 3.4 — — — — — — — 1.1 95.1 64.0 4.2 0.5 12.3 0.6 Government Year Long-Term Short-Term 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 12. 1986-1999 ($ billion) Private Nonbank Long-Term Short-Term 3.1 0.0 Long-Term Short-Term BIBF Commercial Bank Long-Term Short-Term 0.0 0.8 0.1 34.8 31.6 — 0.1 23.3 0.8 108.2 0.3 16.7 24.3 20.3 0.5 16.1 2.0 6.2 15.3 7.1 Source: Bank of Thailand.8 3.4 3.9 5.8 13.6 1.9 7.1 22.9 6.0 13.5 14.2 2.3 3.9 4.3 37.5 4.3 0.4 18.2 10.2 32.9 11.9 0.6 18.9 3.3 10.8 3.1 0.7 10.0 21.4 2.6 7.9 13.9 35.7 13.7 2.3 0.3 0.3 0.7 109.2 2.5 4.9 1. .1 30.9 10.5 12.1 12.9 10.0 11.2 0.1 0.1 0.9 100.3 2.4 15.7 1.1 5.0 8.2 2.3 0.3 3.
the index declined to 1. If lending rates remained high. The proportion of NPLs as a percentage of outstanding loans demonstrates the liquidity problem experienced by the corporate sector. NPLs spiraled from 12 percent in the second quarter of 1997 to almost 40 percent in the third quarter of 1998.6 in December 1996. Even before the crisis. and (iii) bankruptcies. Most of these foreign debts were not properly hedged. from its peak in 1995.Chapter 4: Thailand 263 This shows that although banking and finance companies suffered most because of their short-term exposure. Due in part to liquidity problems on the one hand. It hit a 10-year low in the second quarter of 1998. suggesting that serious investors have not returned to the market. leaving domestic investors with large capital losses. (ii) the rise in the nonperforming loan (NPL) ratio and consequent tightening of credit even for viable firms. foreign currency-denominated debts constituted 55 percent of their total debt portfolio. the numbers of bankruptcies and company closures reached all-time highs in 1998 (Table 4. SET’s dismal performance is indicative of the extent of the setback suffered by the Thai capital market. reaching 45 percent of total outstanding credit in December. according to the Bank of Thailand.6 billion from the 1996 level of B201 billion. Trading volume has since been thin. the number of newly registered companies dropped to a 10-year low in 1998. exposing the companies to disaster when the baht started tumbling on 2 July 1997. The effects of the crisis were felt across all industry sectors. trading activity at SET had been on the downturn. Aside from the problem of NPLs.281 in December 1995 and to 831. The severity of the impact of the crisis on the corporate sector was apparent from (i) the decline in the volume of public offerings. and drastic decline in the number and capital of newly registered companies.17). the SET Index stood at 1. outstanding credit also declined throughout the second half of 1998. banks would be recording more of such NPLs. large Thai companies had actively borrowed at low interest rates from foreign financial institutions.360. With easy access to foreign funds. On average. . based on the three-month past due definition. The value of public offerings sank in 1997 to B56. Similarly. nonfinancial companies also experienced severe liquidity problems as a result of the baht’s devaluation. 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. At the end of 1994. After that. the liquidity problems faced by the corporate sector are likely to continue for some time. Foreign investors retreated from the market. closures. Meanwhile. and poor business confidence on the other.
As part of the assistance package. 1985-1999 Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Newly Registered 10.307 4.695 3.288 35. The first Letter of Intent was cosigned by the Minister of Finance and the Governor of the Bank of Thailand on 14 August 1997. A steady price decline over the past few years has dragged down the ratio of market price to book value.6 in 1997. But when assistance from other sources did not materialize.134 31. The increase of the P/E ratio in 1998 was mostly a result of a decrease in earnings for most listed companies.264 Corporate Governance and Finance in East Asia.2 billion for balance of payments support and buildup of the country’s reserves.410 37.777 11. The IMF financial package was a credit facility of $17. Vol. .977 Source: Department of Commercial Registration. the Government was left with no choice.218 3.409 6.410 5.095 14.925 12. the Thai Government was lukewarm to the idea of obtaining IMF assistance because of the requirements and conditions attached to the financial package.677 Bankrupted/Closed 2. It also explains the higher dividend yield ratio. 4.792 7.933 25.407 28.334 4.904 20.797 4.105 4.312 25.17 Number of Newly Registered and Bankrupted/Closed Companies. Thailand.2 Responses to the Crisis Initially.052 36. Ministry of Commerce.5 at the end of 1994 to 12 in 1996 and further to 6.224 4.066 19.080 9.112 9. II Table 4.201 24. IMF required Thailand to meet a set of performance criteria and implement various restructuring measures.902 3.096 22.5.915 37. The price-to-earnings (P/E) ratio deteriorated from 19.
and restore solvency. Regulatory Response by the Government The IMF program. loan provisioning. The Bank of Thailand also improved banking standards. it was widely interpreted as “having debts more than assets. Under the old bankruptcy laws. In early 1998. debtors could drag out the process for many years. IMF relaxed these key conditions. As it turned out. also aimed at institutionalizing legal and regulatory reforms. For example. and income recognition were implemented. These include repeal of the Commercial Bank Act. and Credit Foncier Businesses. only two companies emerged intact from the suspension. the Civil and Commercial Code. Creditors could negotiate to reschedule debt repayments. Many believed that the process was inefficient. They could seek civil action through the courts and could also use criminal sanctions to enforce debt repayments. drawn up with World Bank and ADB assistance.” Creditors thus bore the burden of proving a debtor’s insolvency before the courts. and worked on revisions to the Secured Transaction Law. The Government also passed the Bankruptcy Act and Foreclosure Act Amendments. and if necessary.Chapter 4: Thailand 265 The terms of the agreement required the Government to maintain tight monetary and fiscal policies. increase profitability. and the Act Regulating the Finance. The Financial Sector Restructuring Authority was established in October 1997 to address the problems of 58 finance companies that were suspended in 1997. however. and did not recognize debtor-initiated bankruptcy declarations. The old law allowed only creditors to file bankruptcy suits. Strict loan classifications. The assets of the other companies were liquidated by auctions. Securities. The Government required all remaining financial institutions to recapitalize and instituted closer monitoring measures to ensure full compliance with this requirement. follow through with a civil or bankruptcy suit. secured creditors had to obtain the court’s approval before starting proceedings . creditors seldom succeeded in obtaining payment against bankrupt borrowers. The core of the IMF conditionalities was the restructuring of the banking and financial sector to regain investor confidence. By invoking procedural loopholes. There were many options for solving debt repayment problems. Several changes in the banking and financial policy environment have been effected in line with the restructuring program. While no definition for “insolvency” could be found in the bankruptcy law.
which means that a debtor could continue in business while the reorganization program was being implemented. but it is a complicated. 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. Companies need . The amendment added reorganization provisions to the Bankruptcy Act of 1940. Chapter 11 is the main tool in restructuring bankrupted companies in the US. time consuming. In Thailand.266 Corporate Governance and Finance in East Asia. The amended law also introduced the concept of automatic stay. Vol. In effect. thereby allowing court-supervised corporate restructuring. 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. The reorganization process is successful if (i) the debts shall have been discharged. If the process fails to revive the business. The amended legislation also includes voluntary bankruptcy as a new feature. For one. The model for Thailand’s amended bankruptcy law was the US Chapter 11. In 1999. The original Bankruptcy Act dealt only with liquidation and composition. and expensive process. Foreign secured creditors had to go through the motions of establishing that their country of domicile granted Thai creditors similar rights. any new loan to a company extended after the creditor discovered the insolvency would not be eligible for repayment. To make matters worse for creditors. (iii) shareholders regain their legal rights. (ii) management of the company reverts to the borrower. the judges and court officers have yet to learn and master the new bankruptcy procedure. the National Assembly passed an amended Bankruptcy Act and approved the establishment of special bankruptcy courts. II for the recovery of debt through the realization of any collateral. the company shall be declared bankrupt and liquidation of assets shall follow. There are other potential problems. and (iv) the debts shall have been settled within a five-year period. 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. 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. it covers only the court-supervised reorganization of distressed companies. Enforcement of the new law is bound to be ponderous and lengthy. Chapter 11 cases account for only 5 percent of bankruptcy suits in the US but consume 90 percent of the courts’ time. Under the old Bankruptcy Act. But more important.
questions have been raised regarding the appropriateness of the 1992 Act. however. the test for insolvency still uses the balance sheet criterion. after determining the legitimacy of the request. The proposed new law seeks to expand the type of assets that a borrower can use as collateral.Chapter 4: Thailand 267 to solve the problems (e. . namely “liabilities exceed assets. Procedural delays give borrowers an advantage because they can refuse to pay back their loans even though they can meet their obligations. In case the board of directors does not comply. which aims to increase liquidity in the domestic economy by allowing businesses to use both tangible and intangible assets in securing credit. the court. 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. 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. In the past. shall have the power to call the extraordinary general meeting. Without the necessary corporate restructuring. The amendment seeks to revise old rules and procedures that tended to delay foreclosure proceedings. has not been satisfactory. Replacing the Public Limited Company Act of 1978.” as opposed to the more appropriate criterion of “ability to pay when the debt falls due. corporate governance) that caused the bankruptcy in the first place. Most important. The result. SEC also examined the possibility of an amendment to the Public Company Act of 1992. only tangible assets were the norm.g. the Bankruptcy Amendment will just prolong the problems of nonviable borrowers. Still pending Parliament approval is the amendment to the Secured Transaction Law. Consequently. 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. The minimum shareholding requirement is too high for any individuals or groups of minority shareholders to take action against controlling shareholders.” The Foreclosure Act Amendment was likewise passed in 2000. the 1992 Act relaxed some of the original restrictive rules and regulations to encourage public company registration. The proposed amendment also includes a provision for the company to reimburse minority shareholders for expenses related to calling such a meeting. Under the new law. minority shareholders’ rights are not adequately protected.. The amendment also remedies the slow process of executing or disposing of assets in a public auction.
Vol. The regulators are drafting a proposal to amend the provisions on related transactions. This may be true in countries where publicly traded companies are widely held. Because of high ownership concentration. which. to borrow from the company without consideration to the fairness of the transaction or transparency of the approval process. in turn. this is not so in publicly traded companies in Thailand. The 1992 Act also allows directors to engage in business activities that may directly or indirectly affect the company. claiming that it creates fragmentation in the board of directors. II Another issue is the assumption in the 1992 Act that there is a separation of ownership and control functions. with the approval of the board. However. 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 proposal clearly delineates duties of care and loyalty for directors of public companies. it will probably be expensive because of the higher risk that comes with weak accountability mechanisms. In the absence of such a stock market boom now. 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. there are few provisions in the Act that deal with related or connected transactions that potentially reduce shareholders’ value. it permits directors. i. The proposal for the amendment of the Public . Most companies decide against cumulative voting. 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. But because this is the assumption embedded in the regulation. they face the prospect of being unable to compete for the scarce funds available in the equities market. and determine voting results on virtually any matter. The 1992 Act only prescribes—not requires—the use of the cumulative voting procedure. Otherwise. Where equity will come forward. the controlling shareholders have the exclusive domain to appoint or exercise management. But as demonstrated. Consequently. The textbook separation between owners who sit in the company’s board and professional managers who run the company does not apply in Thailand.e.. disrupts the company’s management and decision making. minority shareholders are likely to be wary of increasing their equity without corresponding control mechanisms at their disposal. In addition. minority shareholders have no chance of being represented in the board.268 Corporate Governance and Finance in East Asia. subject only to approval by the board of directors. the main problem is overlooked. without cumulative voting. the dominance of controlling shareholders. vis-a-vis the minority shareholders. who are also the managers.
764 debt restructuring cases involving B1. In response. Another 77. In addition. Considerable progress has been achieved on this front. and manufacturing sectors. Within three months. where bankruptcy procedures are swift and effective. CDRAC’s target debtors comprised 10. The Bank of Thailand issued guidelines in 1998 encouraging financial institutions to specify their own policies. with the majority of the debtors coming from the commerce. 322. The reason is that bankruptcy law amendments appear to facilitate settlements outside the court. By October 2000. and procedures for debt restructuring. contributing to the unprecedented rise in the corporate sector’s bad debt.8 trillion had been completed. methods.6 trillion.1 trillion of outstanding credit. Some 82 percent of these cases have been successfully restructured. the number of cases has abated. As of November 2000. In particular. Commercial banks initiated 74 percent of these cases. 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. personal consumption. accounting for B1. Cases for which negotiations were unsuccessful.1 trillion in outstanding credit. only 7. Another 5 percent of cases (B70 billion) are undergoing restructuring negotiations. although since then. a Corporate Debt Restructuring Advisory Committee (CDRAC) was established in 1998 to map out debt restructuring measures in support of efficient negotiations between the private sector and financial institutions. the Government introduced debt restructuring-related measures to help resolve bad debts.767 cases involving outstanding credit of B2. The first bankruptcy court in Thailand opened on 18 June 1999.6 trillion) have agreed to cooperate with CDRAC’s restructuring process.147 cases (B1. as well as those that did not cooperate with CDRAC’s restructuring process. Reforms in bankruptcy procedures should be seen not only in the context of crisis resolution.068 cases involving B475 billion are undergoing restructuring. will be settled by the courts. accounting for B1. Corporate Debt Restructuring and Bankruptcy The 1997 crisis led to a severe liquidity problem in the economy. This point is crucial because compared with .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. However. Equally important is the contribution of effective and reliable bankruptcy procedures for improved corporate governance.
the Thai Government managed its economy with the corporate sector as the main engine of growth and development. II Malaysia. The study covers the period 1985 to 1996. In the next three decades. Emphasis was on the structure of corporate governance and patterns of corporate ownership and financing of publicly listed companies. Weak bankruptcy procedures were part and parcel of the perverse set of incentives that led firms to build up unsustainable levels of debt. despite the weakness of their disciplinary powers. Reforms through SET and Improved Disclosure The financial crisis prompted SET to introduce a range of improvements to its operation and regulation. Examination of corporate ownership. the Government protected certain corporate sectors through tariffs and regulation. Financial information from listed companies will also soon be required to conform to International Accounting Standards. Such improvements in disclosure standards are part of the efforts of SET and SEC.270 Corporate Governance and Finance in East Asia. The banking industry played a key role in the early stages of economic development because it represented the only avenue for funding Thai corporations. 4. For this reason. 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. 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 1997.1 Summary. behavior. to push companies to harmonize their accounting with international standards. and even Indonesia. Conclusions. and Recommendations Summary and Conclusions This study has provided an overview of the corporate sector and governance in Thailand.6 4. The . The exchange has already required that listed companies’ quarterly reports be directly comparable with annual statements. Vol. 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. and performance during this period helps understand the causes of the crisis. It required listed companies to establish their own audit committees by the end of 1999. and promoted key industries through incentives.6. Philippines.
The study examined the impact of ownership structure on corporate governance and financing patterns. the overall pattern of ownership concentration seems to have been stable for the past 10 years. This implies that the control of an average Thai company is typically in the hands of a few persons (founders or their associates) who own a majority of total outstanding shares. Minority shareholders. the devaluation of the baht that began on 2 July 1997 affected the financial condition of Thai corporations. The impact of the crisis was felt across all industries. the number of listed companies in SET fell from 454 in 1996 to 392 in 1999. the overall corporate sector was seriously affected. the increase in long-term debt more than compensated for the drop. Because most of these debts were not hedged. One of the principal causes of the crisis was the excessive use of foreign debt by the corporate sector. One of the major findings is the high ownership concentration among Thai companies listed on SET. Although there are some variations across industries. Nonbank private corporations accounted for most of the increase. The SEA of 1992 also marked the beginning of an active bond market in Thailand. Thai companies were vulnerable to exchange rate risks. On average. the top five largest shareholders hold about 56 percent of total outstanding shares. At the same time. 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. Although there was a decline in short-term foreign debt. Meanwhile. During 1992-1997. even after the development of capital markets. In 1995 and 1996. In 1992. . Consequently. there was a marked increase in the number of public corporations. Subsequently. At the onset of the 1997 financial crisis. at a time when most of them were already experiencing declining profits and high leverage. foreign debt in the Thai corporate sector increased continuously. the number and value of public offerings of securities accelerated. The number of newly registered companies in 1997 dropped by almost 10.Chapter 4: Thailand 271 importance of bank financing continued throughout the 1990s. the numbers of bankruptcy cases and company closures reached alltime highs. After 1992. reaching its peak in 1996. the corporate sector entered a new era with the enactment of two major pieces of legislation. Profitability increased throughout the 1980s but began to decline in the first half of the 1990s.000 from the previous year’s level. the profitability of publicly listed companies abruptly declined and their financial leverage increased. the Public Company Act of 1992 and the SEA of 1992.
along with a highly concentrated ownership structure. the government pension fund was the only major institutional investor.272 Corporate Governance and Finance in East Asia. publicly listed and unlisted companies in Thailand are equally subject to the consequences of the risk-taking behavior of controlling owners. foreign and domestic. Among the five largest shareholders of Thai companies listed on SET. The investing public holds the rest of the outstanding shares. the mutual fund industry has entered the picture but with limited roles and activities. contribute to the lack of external controls on the corporate sector through the capital markets. The absence of external market controls on the management of publicly listed corporations is dangerous. An analysis of the corporate ownership structure in Thailand suggests that founders and management continue to own and control publicly listed Thai companies. Institutional investors in Thailand. they have little influence over management decision making and control. Consequently. Recently. With financial institutions playing limited roles in the capital market. II although larger in number. Nominally. holding companies and affiliated corporations hold the largest proportion at 27 percent of total outstanding shares. In the past. Individuals and insiders hold the second largest proportion at about 19 percent. there is a clear lack of outside monitors for these publicly listed but family-controlled companies. through the use of holding and affiliated companies. Financial institutions hold a very small proportion. are not active. Most foreign institutional investors invest only on a short-term basis and aim for short-term trading profits. the existing legal and regulatory framework suggests otherwise. The key laws. commercial banks hold only about 2 percent of total outstanding shares while nonbank financial institutions hold about 6 percent. The rules in both Acts governing . averaging 46 percent. All these. 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. The implications of ownership structures that are concentrated to such a high degree are serious. protect the interests of all shareholders of public companies. Vol. The highly concentrated ownership structure weakens the protection of minority shareholder rights. hold only a small portion of total outstanding shares. Thus. the Public Company Act of 1992 and the SEA of 1992. These laws stipulate rules and regulations concerning the activities of all public companies. The Government holds about 1 percent of total outstanding shares but these holdings represent majority shares of a few companies.
Ownership concentration appears to have little impact on corporate profit performance.6. posed formidable barriers in the minority shareholders’ exercise of their rights. because there are shared interests between the controlling shareholders and key management personnel. The Government has been moving to amend the Public Company Act of 1992 to increase minority shareholders’ protection in this regard. because there is no separation between ownership and management. the Public Company Act of 1992 allows shareholders to act only when they hold a minimum proportion of shareholdings. The first issue involves the development of a comprehensive supervisory framework and the strengthening of the capacity of supervisory agencies. In view of this. the main challenge is in protecting minority shareholders from the possibility of expropriation by the majority. the main challenge is not how the board can control management to maximize shareholder value. key reforms that will strengthen the regulation of financial institutions. For instance. laws did not provide minority shareholders sufficient safeguards in cases of transactions involving companies where the controlling shareholders had related interests. a requirement impossible to meet due to the concentrated shareholdings of founding family members and management. However. The ownership structure of Thai listed companies also significantly affects company behavior. Consequently. moreover. For example. but is significantly related to financing patterns. making them vulnerable to economic shocks. In this third area. The second issue involves the protection of shareholder rights.2 Policy Recommendations There are three major policy issues and recommendations that could improve corporate governance in Thailand. these companies tend to become overleveraged. The third issue involves creating external market controls through better regulation and development of the capital markets. Certain provisions. . Rather. It appears that founding family members use debt extensively to finance investments because they want to preserve control of their firms. the degree of ownership concentration has a statistically significant positive relationship to the degree of financial leverage. the high ownership concentration of many listed Thai companies inhibits the effectiveness of these provisions. an aim that can be achieved mostly through legal reforms.Chapter 4: Thailand 273 minority shareholders’ participation in decision making and in initiatives against management conform to international standards. before the crisis. 4. Specifically.
This is due to the historical development of the Thai corporate sector: before 1975. SET was mandated to supervise listed companies. SET. The Government must develop an overall framework for corporate sector supervision and redefine the regulatory jurisdiction of each agency along functional lines. and SEC) are involved in corporate supervision. three major government organizations (the Ministry of Commerce. this is a problem in Thailand. voting only on major decisions. and after the enactment of the SEA in 1992. in 1975. Consequently. the supervisory agencies also need to be empowered to enforce the laws. As in other crisis economies in the region. SEC was established as another supervisory agency. in most of Thailand’s publicly traded firms. the key issue in corporate governance would then be to ensure that managers act in the best interests of the shareholders. the Ministry of Commerce had the sole supervisory responsibility. There is also supposed to be separation of ownership and control. Vol. the principal shareholder typically plays a key role in management and often serves as the chief executive officer. the key issue in corporate governance is how to prevent insiders from expropriating assets of minority shareholders. In this setting. If the principal shareholder is in fact chair of the board. If this were the situation. In reality. . the supervisory system is fragmented and not as effective as it should be. Under the current system. The best approach may entail establishing a single.274 Corporate Governance and Finance in East Asia. It is important that the roles and responsibilities of each agency are clearly defined to the public. unified supervisory agency or a permanent regulatory division consisting of supervisory units from the three agencies. and increase the participation of institutional investors are imperative. Protection of Shareholder Rights The common assumption is that publicly traded corporations are widely dispersed in terms of ownership. activate the market for corporate control. Only then will these agencies be able to act promptly and effectively. Development of a Comprehensive Supervisory Framework There is a need for the Government to establish a comprehensive supervisory framework for the corporate sector. The owners of a firm rely on a board of directors to supervise the managers. with control delegated to professional managers. The board therefore plays a pivotal role. Once the roles and responsibilities are clearly defined. he/she often has the decisive vote. II encourage market competition.
and . Since the Asian financial crisis. The situation prompts two specific recommendations. The first recommendation involves the repeal of current legislation to allow minority shareholders to have greater influence over management decision making. This move is expected to be unpopular among founding family members and original owners. 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. and a prohibition of connected transactions by directors or management. SEC is exploring the possibility of amending the law toward this direction. This includes prescribing ways to empower minority shareholders without disrupting the company’s operations. The Ministry of Commerce is conducting a study on proposed amendments to the Public Company Act of 1992. requiring cumulative voting for the election of directors. Because these holding companies control a number of large public companies in Thailand. The slow improvement in the legal framework has likewise obstructed progress in this area. increasing penalties for directors engaged in misconduct.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. 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. Both SET and SEC are taking an active stance in improving the transparency and efficiency of Thai capital markets. To ensure a level playing field. accountability. regulators must increase transparency and step up enforcement. transparency. The second recommendation is to dilute ownership concentration through the use of regulatory power. the Government can change the shareholding limit for controlling shareholders. they should be monitored and regulated. there has been much progress in this area. The current ownership structure leads to ineffective corporate governance and inadequate protection of minority shareholders. But weaknesses in accounting and auditing practices have been inhibiting the development of capital markets. Through an amendment in the Public Company Act. 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. Some of the legal reforms under consideration concern settling conflictof-interest situations with significant effects on minority shareholders. SEC has been trying to lay the foundations of good corporate governance by espousing fairness.
aimed at ensuring that banks finance only creditworthy projects. A well-developed domestic debt market will provide corporations with an alternative to bank financing. II responsibility among companies. for instance. especially in the area of connected lending. the power of the capital market to discipline inefficient management is almost nonexistent. . it will be difficult to improve corporate governance in Thailand. 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. Vol. the SEC’s disposition toward a largely voluntary approach for adoption of these characteristics has resulted in uneven compliance among public companies. Further. Without a strong and efficient capital market. which. will lead to the emergence of a reference yield curve. In the stock market. The first step is to establish an active secondary Government bond market. it is important to explore reforms that can lead to the enhanced role of banks in monitoring enterprises. Because the financing of Thailand’s corporate sector is predominantly bank-based and will remain so for a long while yet.276 Corporate Governance and Finance in East Asia. The variety of debt instruments available to the corporate sector and investors should be increased and longer-term sources of bond finance actively promoted. This may not be possible without reforms in the banking sector itself. There will be no incentive for companies to raise capital in the equities market if they can obtain funds at a lower cost elsewhere. a well-developed secondary market will pave the way for market disciplinary forces to act against poorly managed companies. However. The same goes for improvements in the bankruptcy system. Capital Market Development and Regulation Another important issue concerns the development of capital markets. Accounting standards have also been under review. there is a need to increase market disciplinary power through market competition. in turn. while a strong domestic debt market will also offer protection from foreign exchange risk. In an environment of highly concentrated ownership. will incidentally close off easy sources of finance for companies that have been practicing regulatory arbitrage. 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. Thailand should develop a strong public debt market to supplement the banking system in financing corporate investments.
PACAP-Thailand Database.Chapter 4: Thailand 277 References Annual Report. Bank of Thailand Quarterly Bulletin. 1997. 1995. . 1995-1999. 1997. 1997-1999. The Securities and Exchange Commission of Thailand. Pacific-Basin Capital Markets Research Center. Fact Book. Kingston. The Thai Bond Dealing Centre. Thai Accounting Standards. The Securities and Exchange Commission of Thailand. 1998. The Stock Exchange of Thailand. 1995-1999. US. The Stock Market in Thailand. Bank of Thailand. Department of Commercial Registration Database. The University of Rhode Island. Ministry of Commerce. The Stock Exchange of Thailand. Bank of Thailand. Bank of Thailand Monthly Bulletin. Key Capital Market Statistics. Bond Market Development in Thailand. The Stock Exchange of Thailand. Thailand. 1995-1999.
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