Corporate Governance and Finance in East Asia

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

Country Studies

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

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


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

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

53 53 55 55 60 62 65

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

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

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

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

1997 Table List of Tables 1.18 GDP Growth by Sector.1 Listed Firms with Positive Economic V alueAdded.14 Banking Sector Outstanding Loans. 1996-1998 2.16 FinancingPatternsofPubliclyListedNonfinancial Companies.20 ROE of the Banking Sector. 1996-1999 Table 1. 1993-1997 Table 1.5 Financial Performance of Publicly Listed Companies by Sector. 1986-1996 Table 1. Indonesia Table 1.2 Foreign Capital Flows.4 Development of the Stock Market. 1996-1998 Table 1.10 Anatomy of the Top 300 Indonesian Conglomerates. Republic of Korea Table 2.6 GrowthandFinancialPerformanceofState-Owned Companies.3 Subsidiaries of the 30 Largest Chaebols Table 2. 1992-1997 Table 1.3 GrowthandFinancialPerformanceofPubliclyListed Companies.17 DER of Listed Companies by Degree of Ownership Concentration Table 1.19 DER and ROE of Publicly Listed Companies by Sector. 1992-1995 Table 1. 1990-1998 Table 1. 1993-1999 Table 1. 1988-1996 Table 1.13 Presence of Board Committees in Listed Companies Table 1.4 Growth Performance of Publicly Listed Companies by Sector.15 V alue of Stocks Issued and Stock Market Capitalization. 1992-1998 Table 2. 1992-1999 Table 1. 1985-1998 6 7 9 11 12 14 14 18 19 21 26 27 28 32 33 34 36 39 40 41 41 54 56 61 63 .12 CharacteristicsoftheBoardofDirectors Table 1.1 Growth of the Banking Sector.11 CharacteristicsoftheBoardofCommissioners Table 1.7 Growth Performance of the Top 300 Conglomerates.9 OwnershipConcentrationofPubliclyListedCompanies by Sector. 1992-1997 Table 1. 1992-1997 Table 1. 1990-1997 Table 1. 1992-1997 Table 1.2 KeyMacroeconomicIndicators Table 2. 1992-1999 Table 1.8 OwnershipConcentrationofPubliclyListedCompanies.21 Nonperforming Loans by Type of Bank.

8 Table 2.29 Table 2. 1988-1997 OwnershipConcentrationofListedNonfinancialFirms by Industry.10 Table 2.7 Table 2.14 Table 2.13 Table 2.30 Private Capital Flows to Korea. 1994-1997 Cross-Payment Guarantees of the Top 30Chaebols. 1988-1997 Features of the 30 Largest Chaebols GrowthandFinancialPerformanceofthe30Largest Chaebols.21 Table 2.18 Table 2. 1995-1997 Ownership Composition of Listed Companies. 1990-1997 InternationalComparisonofRatiosofOrdinaryIncome toSalesinManufacturing GrowthandFinancialPerformanceofSelectedIndustries GrowthandFinancialPerformanceofListedCompanies.15 Table 2.19 Table 2.17 Table 2.16 Table 2. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSectorby Industry Financing Patterns of Listed Companies. 1997 OwnershipConcentrationofListedNonfinancialFirms by Firm Size. 1993-1997 The Top 30 Chaebols’ Debt-to-Equity Ratio.25 Table 2. 1988-1997 Ownership Concentration of the Survey Sample of 81 Listed Firms. 1985-1998 GrowthandFinancialPerformanceoftheNonfinancial Corporate Sector. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSector.26 Table 2. 1999 InternalShareholdingsofthe30Largest Chaebols. 1994-1998 Financing Patterns of the Top 30 Chaebols. 1985-1997 GrowthandFinancialPerformanceofListedCompanies by Size.27 Table 2. 1992-1997 OwnershipConcentrationofListedNonfinancialFirms.9 Table 2.28 Table 2.24 Table 2.6 Table 2.5 Table 2. 1997 Ownership Composition of Listed Nonfinancial Firms by Control Type. 1988-1997 Ownership Composition of Listed Nonfinancial Firms by Industry. 1997 Ownership Composition of Listed Firms in Selected Countries.22 Table 2. 1987-1997 FlowofFundsoftheNonfinancialCorporateSector.23 Table 2.12 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 .vii Table 2. 1997 Ownership Concentration ofAll Listed Firms. 1990 and 1997 Ownership Composition of Listed Nonfinancial Firms by Size.11 Table 2.20 Table 2.

1989-1997 Table 3. 1989-1997 Table 3.viii Table 2. 1988-1997 Table 3. 1988-1997 Table 3.32 Table 2. 1988-1997 Table 3. 1992-1999 . 1997 Table 3.12 Control Structure of the Top 50 Corporate Entities. 1997 Table 3.21 OwnershipConcentration.SectorOrientation.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.4 GrowthandFinancialPerformanceoftheCorporateSector by Ownership Type. The Philippines Table 3.14 Philippine Stock Market Performance. 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. andAffiliated Banks of Selected Business Groups. 1989-1997 Table 3.13 ADB Survey Results on Shareholder Rights Table 3.19 Financing Patterns by Firm Size.6 GrowthandFinancialPerformanceoftheCorporateSector by Firm Size.17 Composition ofAssets and Financing of the Publicly Listed Sector. 1997 Table 3.7 GrowthandFinancialPerformanceoftheCorporateSector by Industry.20 Financing Patterns by Industry. 1992-1996 Table 3.8 Ownership Composition of Philippine Publicly Listed Companies by Sector. Thailand Table 4. 1983-1997 Table 3.33 Net Profit Margins of Chaebols.000 Companies. Flagship Company. 1988-1997 Table 3. 1989-1997 Table 3.2 Public Offerings of Securities. 1997 Table 3.3 TheCorporateSectorandGrossDomesticProduct.18 Financing Patterns by Control Structure.31 Table 2.16 CorporateFinancing PatternsbyOwnershipType. 1988-1997 Table 3. 1990-1999 Table 3.Profitability andFinancial . 1995-1998 4. 1985-1997 Number of Firms with Dishonored Checks.22 Foreign Investment Flows. 1986-1998 Nonperforming Loans of General Banks.1 GDP Growth of SoutheastAsian Countries.11 TotalandPerCompanySales.9 OwnershipConcentrationatCriticalLevelsofControl Over Publicly Listed Companies. 1978-2000 Table 4. 1988-1997 Table 3.1989-1997 Table 3. Leverage Table 3.1 Public Companies Registered.15 Financing Patterns of the Corporate Sector.2 Growth and Financial Performance of the Top 1.5 GrowthandFinancialPerformanceoftheCorporateSector by Control Structure. 1997 Table 3.

1992-1999 Common-Size Statements for Companies Listed in SET.16 Table 4. 1990-1998 StatisticalRelationshipsbetweenCorporateProfitability.3 Table 4.7 Table 4.ix Table 4. 1993-1999 Size and Composition of the Thai Financial Sector.17 StatisticalHighlightsoftheStockExchangeofThailand.12 Table 4.11 Table 4.13 Table 4.2 Figure 3.6 Table 4. 1990-1996 Common-Size Statements of Public Companies by Ownership Concentration.1 Figure 1. 1990-1996 Financial Ratios of Listed Companies by Ownership Concentration. Ownership Concentration. 1992-1999 Offerings of Debt Securities.8 Table 4. 1985-1996 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand.10 Table 4. 1986-1999 NumberofNewlyRegisteredandBankrupted/Closed Companies.9 Table 4. and Company Size Top-Five Shareholder Composition of Publicly Listed Companies in Thailand. 1985-1996 Average Key Financial Ratios by Company Size.14 Table 4. 1990-1998 Merger and Acquisition Activities. 1990-1996 External Debt. 1990-1996 Financial Ratios of All Listed Firms. 1985-1999 237 238 239 241 242 243 251 252 256 258 259 260 261 262 264 List of Figures Figure 1. 1993-1999 Key Financial Ratios of Publicly Listed Companies. Leverage.4 Table 4.2 TheSuhartoGroup TypicalInternalOrganizationalStructureofaPublicly Listed Company in Indonesia CorporateControlStructure:TheCaseofAyalaCorporation CorporateControlStructure:theCaseofLopezGroup 24 25 195 197 .15 Table 4.5 Table 4.1 Figure 3.


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

Arvind Panagariya ChiefEconomist


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


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

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

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

1 Indonesia
Saud Husnan1



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

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

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

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

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

However. and increased access of domestic banks to international financial markets. Consequently. the legal infrastructure that was supposed to guide the evolution of the banking sector was not backed by effective enforcement. The initial banking sector reform was introduced in 1983. But in terms of assets per bank. which up to then was channeling oil revenues to priority sectors. Since 1977. Further reforms along the same direction and affecting state-controlled banks came in the 1990s. to date. Conglomerates carried out 210 out of 257 IPOs. 1. which were previously constrained to 4 percent per day. the number of listed companies in the stock exchange increased substantially. six SOCs had issued equities in the market. companies could no longer enjoy low-interest credit from state banks.3 The Banking Sector Despite the development of the stock market.Chapter 1: Indonesia 5 At the end of 1988. with a total value of more than Rp8 trillion. These included the opening of the banking industry to new entrants. from 24 in 1988 to more than 300 in 1997. began to face competition.2. Thus. the capital market played an increasing role in raising long-term funds needed by the corporate sector. In 1988. the controlling shareholder of these SOCs is still the State. The dominance of state banks started to erode. the banking sector has been and still is the major source of credit for the corporate sector. state-owned banks were still among the biggest. Partly as a result of these reforms. However. During this period. The Government also allowed foreign investors to buy up to 49 percent of listed shares. The development of the Indonesian stock market also provided a vehicle for the privatization of state-owned companies (SOCs). with a total value of Rp16. The Government also abolished the practice of setting prices for IPOs and removed restrictions on price movements in the secondary market. private domestic banks dominated the sector in terms of number and total assets. . priority credits still enjoyed subsidized interest rates and funding from the Central Bank.5 trillion. the liberalization of the banking industry allowed banks to determine lending rates for nonpriority loans. Table 1.1 shows that from 1994 to 1998. the banking sector has undergone many reforms. However. more significant reforms were introduced. the number of private domestic banks increased. Through the years. reduced restrictions on foreign exchange transactions. The banking sector. Interest rate regulations on state banks and credit ceilings in general were removed.

9 27 113.4 10 35.9 304. Vol.8 27 147.5 27 88. and Bank Umum Nasional (BUN) have failed and the first two are now under management of the Indonesian Bank Restructuring Agency (IBRA).4 239 222 208 173 Assets and liabilities were concentrated in the top 10 banks.3 27 51.5 528.5 27 66.4 789. 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.6 7 7. BCA. Bank Danamon (ranked 7th).7 27 37. private domestic banks among the top 10 in 1997 included Bank Central Asia (BCA) (ranked first and linked to the Salim group). Because regulation was weak. and Bank International Indonesia (ranked 9th).9 762.9 248.5 7 9.1 Growth of the Banking Sector. 1993 100.9 291. the 10 largest were all affiliated with major business groups.6 7 12.9 39 18.6 34 14.1 10 47.3 10 17. Bank Danamon.9 10 11.3 201.6 164 144 130 92 387.8 391. Both BCA and BUN have shareholders linked to the former President Suharto.4 34 12. In terms of assets.1 240 1995 122.7 351. 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.8 27 200.9 31 9.8 166 248.8 10 37. while BUN has been closed down by the Government.8 31 10.8 10 19.6 240 1996 1997 1998 1999 141. The other banks among the top 10 were state banks.5 165 308.3 30 7. But the banking system proved incapable of performing its intermediation function.6 Corporate Governance and Finance in East Asia.2 10 14.5 7 7 7 5 15. II Table 1. banks could earn profits even when they did not gather and process information about risk. Of these. Among private domestic banks.0 234 1994 104.2 161 214.8 29 6. .

except in certain strategic sectors. Most FDIs came in through joint ventures with business groups having strong political connections. when the financial crisis hit Indonesia. In effect. November 2000. 1.4 Foreign Capital The years of rapid industrial growth attracted a large amount of foreign direct investments (FDIs).59 billion in 1996.09) (0.2 Foreign Capital Flows. and footwear. Table 1. foreign creditors were eager to provide financing to Indonesia. But FDIs were only one form of foreign capital inflows to Indonesia. textiles.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. especially through bank loans.59 4.78 2. In 1994.40) (0. FDI flows were strong. there was a phenomenal growth in direct borrowings by Indonesian corporations.00 2.2.48 1.74 5.2.87 7.09 1.01) (0.33 (13.11 3. Net FDI flows increased to $5. In the 1990s. Between 1990 and 1996. Until the onset of the crisis. the Government allowed foreign investors to own 100 percent of an Indonesian company. Successive policy deregulation facilitated FDIs in various light manufacturing industries. IMF.81 3. Although these inflows were not nearly as large as those received by Thailand (10 percent of GDP) and Malaysia (9 percent of GDP).15) — = not available. September 2000.01 (2. . there was an explosion of credit for which the probability of repayment was based on little but blind faith in the sustainability of rapid growth and on the presumption that political connections were as good as government guarantees against bankruptcy of borrowers. they still amounted to a large sum for the economy to absorb.88) — — — — — — 8. Increasingly. Source: IFS CD-ROM.63) (1. Joint BIS-IMF-OECD-World Bank Statistics on External Debt.50 (0. as shown in Table 1. initially from Japan and the Republic of Korea. Indonesia received capital inflows averaging about 4 percent of GDP.10 5.88 4. such as metal goods.09) 1. From the mid-1980s until July 1997. 1990-1998 ($ billion) Type of Flows Net FDI Net Portfolio Investment Foreign Bank Loans 1990 1991 1992 1993 1994 1995 1996 1997 1998 1. foreign investment also had a strong presence in the services and infrastructure sectors.

an interesting question is whether standard measures of corporate profitability and performance also indicated the same. By the end of 1997.5 Growth and Financial Performance While it was obvious that the term structure and currency composition of debt suggested problems in the run-up to the crisis. plus 4 percent for the depreciation of the rupiah. Vol. total corporate debt reached nearly $118 billion. and conglomerates. 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. . This increased to 30 percent by the end of 1993. The following section looks at the growth and financial performance of the corporate sector. participation in the Indonesian stock market was exclusive to domestic investors. the average foreign ownership of listed companies was 21 percent. Between 1989 and 1992. allowing foreign investors to buy up to 49 percent of stocks of a publicly listed company. 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. 1. The Government relaxed this restriction in 1988. the average borrowing rate for dollar loans was 9 percent. II Up until the late 1980s. In September 1997.4 trillion in 1997. of which two thirds were rupiah-denominated. foreign banks became a significant source of financing for the corporate sector. In November 1998. but declined to an average of 25 percent during 19951997. 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. Private borrowers preferred foreign loans since these were relatively cheaper. Capital account liberalization permitted the inflow of foreign capital that fueled the credit boom in the country. the analysis focuses only on publicly listed companies. Domestic corporate debt was about $50 billion equivalent. In the 1990s. state-owned companies (SOCs). From 1987 to 1996. with the onset of the Asian crisis. increasing the total trading value from Rp8 trillion in 1992 to Rp120.2. The external corporate debt owed to foreign commercial banks was $67 billion.8 Corporate Governance and Finance in East Asia. foreign investors began to dominate daily trading. Consequently. especially the short-term ones. Due to data constraints. The excessive dollar borrowings made the corporate sector vulnerable to sudden currency fluctuations. This is lower than the average borrowing rate of 18 percent for loans in domestic currency.

4 38.2 30.0 6.1 220. 1995.1 percent in 1997 when the crisis began to buffet Indonesia.7 — = not available. 174 firms.0 12.8 percent between 1992 and 1996. The growth of listed companies was sustained by continuing investments. 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. but turned negative in 1997. 250 firms.9 310.5 34. 226 firms.3 shows the growth and financial performance of Indonesian publicly listed companies.3 6. ranging from 220 to 250 percent between 1992 and 1996. the average DER increased to 310 percent from 230 percent the . The debt-to-equity ratio (DER) was high compared to those of listed companies in Malaysia and the Philippines.7 — 250. and 1992.8 220. b Asset turnover is defined as sales over assets. but fell to 24.9 37.2 7.0 1. Despite such rapid growth. Note: The number of firms is not identical for each year. publicly listed companies as a group contributed less than 10 percent to GDP. Return on assets (ROA) was also relatively stable during 1992-1996.7 percent in 1997. During 1992-1997. a Value added was assumed to be 30 percent of total sales.0 3.5 37.5 3.7 3. 248 firms.0 11. Source: JSX Monthly (several publications). but declined to 0. 1993. 1996.1 4. although the contribution increased over time. In 1997.0 33. Asset turnover was above 30 percent until 1996.3 Growth and Financial Performance of Publicly Listed Companies.Chapter 1: Indonesia 9 Publicly Listed Companies Table 1. while total assets grew at 43 percent. 246 firms.6 48.6 1994 50.0 12.4 31.0 12.6 24.3 3.5 34. averaging 3. total sales of listed companies grew at an annual average rate of 31 percent.6 3.2 1995 37. but dropped to 1.1 0.8 230.0 64.4 1996 18.0 10.4 1993 45. Table 1. Net profits grew at an annual rate of more than 20 percent from 1992 to 1996.5 240. When the crisis battered Indonesia in 1997.4 1997 7. 1994. there were 204 firms.6 percent in 1997. Average return on equity (ROE) of listed firms was 11.4 percent.8 6.

Also.4). This sector was less affected by the crisis. it appeared that the performance of listed companies was quite satisfactory prior to the crisis. indicating its reliance on equity to support growth. In terms of sales and asset levels in 1997.3 percent between 1992 and 1996. and trade) even posted . The finance sector’s contribution to GDP. followed by agriculture (Table 1. The same applied to the trade sector. the mining sector ranked first. The ROE levels suggest that high leverage enabled listed companies to achieve high returns on equity. the property sector was severely affected by the crisis. mining. investment. Most companies in the sector that had unhedged dollar-denominated loans suffered exchange rate losses when the rupiah weakened. and building construction sectors had the highest DERs because companies in these sectors found it easy to obtain credit from banks.10 Corporate Governance and Finance in East Asia. Overall. the mining sector had the highest ROE. In terms of share of value added to GDP. only two sectors (mining and finance) showed a consistently increasing trend from 1992. trade. averaging 21. consumer goods.5 presents the financial performance of listed companies by sector. Vol. and property. with ROE falling to -11. which operated in nickel and copper mining in 1992 and 1993. and services.64 percent in 1997. real estate.2 in 1997. the companies in the sector did not operate with a high leverage. when the property sector was booming during 1993-1997. averaging 17. From 1995.73 percent in 1992 to 1. Before the crisis. Four sectors (basic industry and chemicals. helped in part by the relatively strong demand for consumer goods. For instance. The consumer goods sector ranked second in terms of ROE. ROE fell drastically because the sector had one of the highest DERs. increased from 0. the mining sector had the lowest DER. property. and services. meanwhile. although asset turnover was slow. and building construction. in terms of growth of sales and assets. finance. The Jakarta Stock Exchange (JSX) classified listed companies into nine sectors: agriculture. due mainly to the domination of the International Nickel Company of Canada. basic industry and chemicals. still posting a positive but lower ROE.7 percent during 1992-1996. Meanwhile. the fluctuation in nickel and copper prices contributed to the oscillation of ROE. investment. ROA of all sectors dropped in 1997. the banks eagerly provided credit to property development companies. Table 1. infrastructure. property. real estate. However. During those years. and trade. The finance. But the sector’s ROE fluctuated a lot. the dominant sector was the finance sector. When interest rates increased. miscellaneous industry. miscellaneous industry. II previous year. This indicates that a substantial part of corporate debt was denominated in dollars and unhedged.

1 23.6 24.2 11.8 0.5 53.1 1.5 (8.3 0.6 0.5 (11.4 1.3 340.6 28.8 32.5) 13.2 0.9 14.8 1.8 66.. 1992-1997 (percent) Indicator/Sector Sales Growth Agriculture Mining Basic Industry and Chemicals Misc.7 1995 51. Industry Consumer Goods Industry Prop.8 1..7 34.4 1. Real Estate. Infrastructure Finance Trade.1 32.3 51. Source: JSX Monthly (several publications).5 23.1 0.6 22.0 43. Industry Consumer Goods Industry Prop. Constn.5 45. and Services Asset Growth Agriculture Mining Basic Industry and Chemicals Misc.7 40.4 77.4 Growth Performance of Publicly Listed Companies by Sector.3 31.8 29.6 83.5 0.7) 26.4 30.1 1.9 64.3 (203.5 0..0 0.3 0.0 22.7 0.6) 119.1 16. Investment.3) 53.0 68.6 15.5 68.9 31.1 1. Infrastructure Finance Trade.4 44.4) 8.1 0.6 85.4 21.0) 46.7 54.1 67.7 21.1 0.4) 6.9 53.4 30.7 0.5 1.3 1.3 92.1 42.1 0.2 13.1 28.7) (113.7) 17.5) 49.7 28.4 103.0 (20.4 170.6 1.2) 0.6) 19.1 0.5 95.1 0.2 14.4 0.7 (82.4 1993 155.5 92.4 64.0 31.1 1.6 133. Investment.9 54.1 — 39.9 0. and Services Net Profit Growth Agriculture Mining Basic Industry and Chemicals Misc.9 1.9 8.7 17.9 54. Industry Consumer Goods Industry Prop.0 0.6 51..7 — — 11.4 1.2 35.6 1994 (75.6 0.6 135.2 0.7 — 36.0 (192.8 51.6 26.0 16.0 0.0 0.9 123.3 0.8 50.6) 25.9 59.1 0. Investment. Constn.8 24.3 17.2 41.5 61.1 71. Infrastructure Finance Trade. and Bldg.5) 6.0 0.9 (7.1 0.8 27.6 0.7 62.9 .3 31.0 24.0 1996 1997 58.8 (76.9 36.5 13.3 0.6 (0.1 (11.2 5.1 35.6 0.5 1. Industry Consumer Goods Industry Prop.9 25.0 0.8) (12. and Services — = not available. and Bldg.4 31.4 38. Real Estate. Investment.4 (149.0 (28.4 43.6 (41.5 28.3 0.0 18. Infrastructure Finance Trade. 1992 — — — — — — — — — — — — — — — — — — — — — — — — — — — 0.1 (41.5 1. and Services Share of Value Added in GDP Agriculture Mining Basic Industry and Chemicals Misc.5 9.3) 39. Constn. and Bldg.2 41.7 112.8 62.7) (27. Constn.2 59. Real Estate.7 24.8) 0.1 0.1 1.7 90.0 64.7 133.0 1. and Bldg.1 0.8 28.Table 1.7 43. Real Estate.9 0.

8 81. Real Estate. Industry Consumer Goods Industry Prop.0 80.3 18.2 6. Constn. Constn.4 6.1 10.1 3.9 87.4) (1.2 30. Real Estate.3 33. and Services Return on Equity Agriculture Mining Basic Industry and Chemicals Misc.0 160.5 4.9 41.1 1994 80.1 4.6 13.7 13.1 1996 100. Industry Consumer Goods Industry Prop.1 63.0 140.7 4.3 5.4 35.4 4.0 190.7 5.5 13.7 9.0 39.0 9.9 40..2 39.2 (4.5 1995 80.2 13.8 67.9 4.7 1.0 50.5 5. Infrastructure Finance Trade.0 3.0 3.0 11. 1992 20.2 23. and Bldg.7 12.0 380. Investment.6 13.8 382.9 42.4 46.0 100.9 17.0 110.5 56.0 100.9 38.8 5.2 111.0 700.7 26.8 20.2 1993 130.1 9.2 3.4 1.8 25.0 150.8 44.2 8. and Bldg.0 650.2 7.7 4. Industry Consumer Goods Industry Prop.0 100.9 14.8 11.0 150.2 53.0 150. and Services Source: JSX Monthly (several publications).8 16. Infrastructure Finance Trade.0 70.7 4.7 46.0 160.0) 7..7 8. Constn.1 10.3 38.0 66.0 180.0 12.0 8.2 7.0 120.3 17. Industry Consumer Goods Industry Prop.8 8.1 4.7 (3.8 168.0 190.2) 7.0 120.3 0.9 7.4 13.5 4.4 71.0 46.4 13.5 11.7 10.0 1997 230.4 35.4 .4 20.1 1.1 13.8 11. Real Estate.1 9.9 10.1 4.0 110.1 (3.0 210.6 1.0 140.0 17.9 38.0 170. Investment.0 560.. and Bldg.3 17.0 70. and Bldg.8) 8. Investment.0 110.0 80.0 120.0 100. Constn.Table 1.0 69.7 5.6 8.0 (0.8 9.0 680.0 8.1 89.7 12. 1992-1997 (percent) Indicator/Sector Debt-to-Equity Agriculture Mining Basic Industry and Chemicals Misc..7 10.3) 5.5 19.1 7.1 11.3 7.1 6.4 46. Real Estate.0 110.1 (5.4 79.6 19.3 73.7 71.0 80.2 3.0 90.0 650.6 (2. and Services Return on Assets Agriculture Mining Basic Industry and Chemicals Misc.5 7.6 23.7 61.6 14.1 10.3 7.2) 15.5 Financial Performance of Publicly Listed Companies by Sector.8 3.0 60.3 64. Investment.0 130.6 74.6 18.9 29.0 120.0 70. Infrastructure Finance Trade.3 13.0 19.6) 36.7 12.7 8.5 17.6 8.2 11.1 65.0 110.0 180. and Services Asset Turnover Agriculture Mining Basic Industry and Chemicals Misc.0 220.6) 18.0 14.2 15.0 160.0 630.3 1.5 43.1 8.0 110.6 (11.7 1.0 15.8 479.5 14.0 190.0 86.1 2. Infrastructure Finance Trade.4 17.4 5.4 6.0 110.7 10.0 180.

the SOCs’ value added as a percentage of GDP ranged from 6 to 8.6 to 8.7 percent in 1990 to 6 percent in 1996. increasing from 21.1 percent in 1992 to 28. SOCs’ ROE ranged from 6. This was relatively high compared to the 3. growth of net profits and assets was erratic.1 percent in 1993. SOCs diversified into many businesses.4 percent the following year. the Department of Finance supervised 30 SOCs. Assuming a fixed ratio of value added to sales.8 percent between 1992 and 1995 (Table 1. the subsidiaries and affiliates number 459 with total assets of Rp343. averaging 24 and 31 percent. Just like private companies. insurance (11 companies). Trade had the highest ROA of 39. Similarly. respectively. banks (seven companies). Only the agriculture sector showed an increase in ROA in the couple of years before 1997. ROA had been at high levels from 1992 to 1995. but dropped dramatically to 4. there were 58 SOCs with subsidiaries and affiliates. However. which collectively had the largest assets. and finance company (four companies).Chapter 1: Indonesia 13 negative ROA. State-Owned Companies At the end of 1995.3 trillion. The sectoral distribution of 165 SOCs is as follows: nonfinancial (143 companies). registering an average annual rate of 10 percent. much lower than that of companies listed in the stock exchange. The Department of Mining and Energy ranked first in terms of sales of SOCs under its control. SOCs actively operated in various sectors4 under the supervision of “technical” departments. there were 165 state-owned companies (SOCs)3 in Indonesia.7 to 7 percent for publicly listed companies.6). These growth rates were low compared to those for listed companies during the same period. The finance and miscellaneous industry. This was due to large sales by the National Oil Company (Pertamina). and basic industry and chemicals sectors had relatively stable ROA before the crisis. Asset turnover rates were lower relative to those of publicly listed companies. Six SOCs were listed in the Jakarta Stock Exchange. between 1993 and 1995. Taken together.3 percent in 1995. SOCs’ sales growth fluctuated during 1990-1996. but it continuously declined from 370 percent in 1992 to 250 percent in 1995. By 1995.7 percent. indicating SOCs’ declining contribution to GDP. While asset turnover rates of publicly listed 3 4 SOCs are those in which the State has at least a 51 percent equity interest. . For instance. The DER was slightly higher than for listed companies. the ratio decreased from 8.

Table 1. SOCs’ asset turnover rates showed a downward trend from 32.5 percent in 1995. these conglomerates owned 9.1 19. a Value added was assumed to be 30 percent of total sales.0 17.6 28.2 — 370.7 1994 (9.0 12.14 Corporate Governance and Finance in East Asia.1 12.8 11.0 7.5 Conglomerates This study used available data on the top 300 conglomerates in Indonesia.7 13.0 28. but dropped to 11.4 16.1 6.1 32. 1990-1997 (percent) Item Sales Growth Share of Value Added in GDPa 1990 1991 1992 1993 1994 1995 1996 1997 — 17.4 percent in 1994. Assuming a constant ratio of value added to sales.2 — = not available.1 310. 1992 — 7.7 (2. b Asset turnover is defined as sales over assets. but climbed to 30.8 12. 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. mostly private companies.1 30.8 21.3 12.3 250. In 1997.0 8.4 13.4 1993 16.2 percent in 1997 (Table 1. the contribution of conglomerates to GDP increased from 12.3 30.6) 260.4 7.2 23.4 13.7). II companies consistently declined over time. .1) 5. Source: Indonesian Data Business Center. a Value added was assumed to be 30 percent of total sales.4 13.6 1995 25. Their total sales increased from Rp90.5 3.7 Growth Performance of the Top 300 Conglomerates.766 business units.1 trillion in 1990 to Rp234 trillion in 1997.0 8.6 28.0 24.2 18.6 percent in 1994. Source: Indonesian Data Business Center.4 percent in 1992 to 28.6 Growth and Financial Performance of State-Owned Companies.7 16. Table 1.8 percent in 1990 to 13. Vol.0 6.

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

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

Chapter 1: Indonesia 17 Bankruptcy Law Despite loan covenants. the viability of a project). capital adequacy. whether they are individuals. the collateral could take the form of nonphysical assets (e. . 1.1 Corporate Ownership Structure Quality of corporate governance is closely related to corporate ownership structure (see discussions in the Consolidated Report of this study). The two most important elements of ownership structure are concentration and composition. It aimed to protect creditors by providing easier and faster access to legal redress.. or financial institutions. The court can declare the debtor bankrupt upon the request of at least two creditors and default on one loan. Ownership concentration is usually measured by the proportion of shares owned by the top one. A new bankruptcy law was passed in August 1998. etc. net open positions. For instance. Discussions on corporate ownership cover listed companies and conglomerates. holding companies. or 20 shareholders.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.3. Banking Laws Affecting the Corporate Sector Some elements of the banking law also affect the corporate sector. five.g. A Commercial Court was also set up to deal with bankruptcy cases. However. states that a bank is not allowed to provide credit without collateral. 1. 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. creditors of unsecured loans are unprotected when borrowers fail to meet their obligations. the Banking Law (1992). Banking regulations also set lending limits. amended in October 1998. for instance. It reveals characteristics of controlling shareholders. families. 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.

7 1994 48.6.5 Average 48. respectively. and Berlian Laju Tankers (liquid bulk maritime transportation services) issued 48.6 percent. This is because a few companies in the transportation sector issued high proportions of shares to the public.1 4.4 percent. mining. consumer goods. and basic industry and chemicals sectors than in others. II Publicly Listed Companies Table 1.6 3. Data from the Indonesian Capital Market Directory (various publications) show that between 1993 and 1997. When a company goes public.1 0. Rig Tenders Indonesia (shipping services) issued 51. 1993-1997 (percent) Shareholder Rank First Largest Second Largest Third Largest Fourth Largest Fifth Largest Total 1993 50. ownership widely held by the general public is highest in the infrastructure and transportation sector (not shown in the table). The pattern of ownership concentration changed little over this period.0 0.2 11.2 1.9 shows that ownership by the largest shareholder in 1997 was more concentrated in the agriculture. This is partly due to the prevailing practice of raising equity through rights issues in Indonesia.9 14. 2.8 68.2 67.9 2.8. for instance.9 0.0 4.5 1997 48. On average.7 3.7 1996 48.4 2.1 1. The percentage owned by each of the five largest shareholders was 48.6 3.1 13.6 13.5 72. 13.0 1.18 Corporate Governance and Finance in East Asia.5 12.0 0.0 2. the controlling shareholders usually act as standby buyers.5 percent.6 68. This preserves the pro rata share of existing shareholders. Meanwhile.8 1. and 0.8 Ownership Concentration of Publicly Listed Companies.9 2.8 shows average proportions of shares owned by the five largest shareholders of publicly listed companies during 1993-1997.9 Source: The Indonesian Capital Market Directory. about two thirds of publicly listed companies’ outstanding shares were owned by corporations that were directly or indirectly controlled by families. When a company makes a rights issue. the founder usually continues to own the majority of shares through a . Table 1. issued 93.5 16. Vol.9 percent of total outstanding shares.0 67.6 4. 3. Zebra Nusantara (taxi services). Table 1.6. the five largest shareholders owned 68.8 68.3 1995 47.9.

9 1. 1997 (percent) Sector Agriculture Mining Basic Industry and Chemicals Misc.1 1.2 46. Industry Consumer Goods Industry Prop.7 9. Constn.2 15. First Second Third Fourth Fifth Biggest Biggest Biggest Biggest Biggest 54.6 9.1 0.9 3.9 44. and only 0. Legal and regulatory developments may have been impeded by the concentration of corporate wealth in . In terms of capitalization..2 This is confirmed in Claessens et al.1 1. and Bldg.6 percent were widely held.9 Ownership Concentration of Publicly Listed Companies by Sector.0 5. in a cross-country study.4 4. and corruption.1 1.3 36.1 11.4 44.6 percent of total market capitalization while the top 15 families control 61. as well as the existence of corruption. is strong.6 2.7 6. two thirds (67.Chapter 1: Indonesia 19 fully-owned limited liability company (Perseroan Terbatas). Claessens et al. Thus the founder keeps the proportion of shares necessary to retain control over management of the listed firm.8 14.1 13.6 1.5 58.7 1. In fact. These figures suggest that ultimate control of the corporate sector rests in the hands of a small number of families.1 percent) of Indonesian publicly listed companies were in family hands.3 14. 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. (1999) also found. the rule of law.7 13. Util.2 2. (1999).9 50.1 2.1 2.4 1. Table 1. and the efficiency of the judicial system.5 1. which shows that in 1996. Real Estate.6 8.9 44. and Services Average Source: The Indonesian Capital Market Directory.4 54. Indonesia has the largest number of companies controlled by a single family. Infrastructure.1 2.3 0.3 2. on the one hand.3 48. and Transportation Finance Trade. the top family controls 16.9 0.6 0.5 4.4 6. on the other.1 1.4 11.. that the correlation between the share of the largest 15 families in total market capitalization.1 0.2 0.7 percent of the market.3 0.7 4.2 10. Investment. Most of the five largest owners of Indonesian publicly listed companies are limited liability companies rather than individuals.

Family control is said to have positive effects in that it allows group members in conglomerates to make strategic decisions quicker. Vol. ethnicity. But these benefits are few and often dubious compared to the high costs of concentration. the proportion of foreign ownership declined from 27. In September 1997. In Indonesia. Batak. The nonindigenous businesspeople are usually Chinese. foreign ownership increased to 21 percent. The corruption and regulatory problems generated by high ownership concentration by families in Indonesia are likely to overwhelm its benefits. When the Government allowed foreign investors to buy up to 49 percent of listed shares in 1988. This may indicate that the New Order Government. political affiliation. and Padang. resulting instead in a decline in the proportion of foreign investor ownership. it rose to 30 percent. In 1993. accounting for 64 percent of total conglomerate sales in 1988-1996. However. the legal system is less likely to evolve in a manner that protects minority shareholders. conglomerates established before 1969 dominated in terms of sales. II the small number of families and the tight links between companies and the Government. most were established during the New Order Government. 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. Among the top 300 conglomerates. numbering 162 in 1988 and 170 in 1996. the onset of the crisis negated this development. Sundanese. their number increased to 5 In 1997. or other ethnic groups. the Government allowed foreign investors to buy up to 100 percent of listed shares.10 shows the anatomy of the top 300 conglomerates in terms of year of establishment. nonindigenous groups owned a larger proportion of the top 300 Indonesian conglomerates. Indian.20 Corporate Governance and Finance in East Asia. Coordination is easier because informal communication channels exist.5 Conglomerates Table 1. but later declined and steadied at around 25 percent.42 percent in December.55 percent in August to 25. was able to create a favorable environment for business development. there is a dichotomy between corporations owned by indigenous and nonindigenous businesspeople. . Indigenous businesspeople include the Javanese. During 1988-1996. with all its regulations. From 193 in 1988. However. and family origin.

5 22.3 80.8 38.1 21. more than five times its 1988 level.1 41.6 114.7 89.0 15.1 46. In 1996.8 25.6 34.3 36.1 percent of total .9 77.1 103.0 116.8 Source: Indonesian Business Data Centre.1 52.8 57.3 20.1 42. sales of the Bakrie group before it went public in 1990 were only Rp369.7 28.3 134.2 23.0 18.2 29.4 trillion in 1996.0 44.4 57. Conglomeration Indonesia 1997.8 36.4 59.6 12. the number of mixed groups declined from 86 in 1988 to 68 in 1996.9 billion.2 76.5 120.0 28. Their total sales also increased from Rp38.2 30. Meanwhile.8 49.4 86.2 159.1 46.4 18.4 68. its sales reached Rp1.9 42.3 120. 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 9.9 47.7 40.4 37.4 52.8 12.9 73.7 95. While they supplied 20.1 179.5 106.1 87.1 25.2 33.1 33.8 30.9 14. due to their “go public” activities.4 15. For instance.0 58.6 95.10 Anatomy of the Top 300 Indonesian Conglomerates.6 17.7 49.4 22.4 48.7 64.3 43.1 58.9 13.0 31.5 21.6 77.2 12.0 58.9 35.4 19.4 81.9 137.3 101.4 59.4 31.4 16.4 32.7 24.6 trillion in 1988 to Rp137.6 54.8 28.Chapter 1: Indonesia 21 Table 1. 204 in 1996.7 106.2 48.4 69.8 68.4 31.9 trillion.

22 Corporate Governance and Finance in East Asia. In 1996. In November 1997. The well-known official-business alliances are those between Sudwikatmono (former President Suharto’s cousin) and Soedono Salim. Some of them later became public companies by listing in the stock market. But only a handful of these companies are listed in the market. Bank Indonesia. II sales in 1988. Banks owned by groups or conglomerates typically act as a “cashier” that provides credit to companies within the group. Conglomerates were also classified into nonofficial. Average sales of official-related conglomerates were substantially greater than nonoffficial-related ones during 1988-1996. average sales of official-related conglomerates reached Rp1. Only about 13 percent were formed by official or ex-official families. and Fast Food (restaurants). compared with the less than Rp700 billion of a nonofficial-related conglomerate. owns four groups with many subsidiaries and affiliate companies. or have resulted from alliances between entrepreneurs and officials. Indocement Tunggal Prakarsa (cement industry). their contribution declined to 13.2 trillion. Vol. Political alliances between entrepreneurs and officials have often led to the violation of regulations meant to promote prudent business practices in the banking industry. In 1997 and 1998. collectively controlling . and Wisnu Suhardhono of Apac-Bhakti Karya. Official-related groups have owners (or founders) who are or are allied with former or current government officials (or their families). for instance. Djuhar Soetanto. Most of the top 300 conglomerates were established by ordinary citizens. The Salim group. Bambang Rijadi Soegomo. including Indofood Sukses Makmur (food industry). The contraction in the number and economic contribution of mixed groups may be an indication of increasing social polarization along ethnic lines. most of the 16 liquidated banks had violated the legal lending limit set by the central bank. But listed companies within conglomerates were few. which is the largest conglomerate in Indonesia.and officialrelated groups. and Ibrahim Risyad of the Salim group.7 percent in 1996. The Suharto family is the largest stockholder in Indonesia. Out of 174 companies. Prudential credit analysis tends to be ignored. More recent alliances were between Bambang Trihatmodjo (former President Suharto’s son) and Johannes Kotjo. banks that had to be closed down included Bank Surya (owned by Sudwikatmono) and Bank Andromeda (owned by Bambang Trihatmodjo). there were 175 groups that originated from a family business. The high NPLs accumulated by banks within official-related groups could be partly attributed to this practice. In 1996. 117 are jointly owned by the family and 57 are owned by individual family members.

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

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

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


Corporate Governance and Finance in East Asia, Vol. II

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

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

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

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

Chapter 1: Indonesia


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

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

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

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


Corporate Governance and Finance in East Asia, Vol. II

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

BOD 5 5 5 23 38

BOC 1 1 3 35 40

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

Chapter 1: Indonesia


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


Corporate Governance and Finance in East Asia, Vol. II


External Control

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

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

7 112.4 225.5 80. .4 1.2 6. However.9 153. companies considered alternatives to bank loans. Private national banks and state-owned banks were the biggest domestic creditors.2 5.4 percent in 1992.14. stocks. II 1.0 168.4 86. Bank loans.7 122. because of the restrictions discussed below. bank loans were the only instruments available to the corporate sector for short term (working capital) or long term (investment) financing.7 50.32 Corporate Governance and Finance in East Asia. From 34.1 Equities In 1977. new instruments have been introduced to the corporate sector. Data from Bank Indonesia show that from 1994 to 1997.4.6 48. bank credit surged from Rp122.7 18.2 71. jointly providing almost 90 percent of loans until 1997.1 Corporate Financing Financial Market Instruments Prior to 1977. when the Government reactivated the stock exchange. and others offered by nonbank financial institutions or finance companies.3 14. the share of private national banks in outstanding total loans increased to 44. equities became available to the corporate sector. however. this market was not well developed.0 487.9 trillion in 1992 to Rp487. including bonds.6 150.9 234.6 3.4 trillion in 1998.3 188.0 3.0 93.5 7. 1992-1999 (Rp trillion) Type of Bank State-Owned Banks Foreign Banks Regional Govt Banks Private National Banks Total Source: Bank Indonesia.6 6. When the Government liberalized the banking industry at the end of 1988 (which allowed for higher interest rates).5 108. Bank Credit As shown in Table 1. Table 1.3 9.3 66.9 150. private national banks overtook state banks as the dominant credit source.0 6.9 378.6 292.3 60.4 56. remain the major financing instrument for the corporate sector. 1992 1993 1994 1995 1996 1997 1998 1999 68. Vol.5 42.8 193. Since then.4 24.3 111.14 Banking Sector Outstanding Loans.6 percent in 1997.2 27.1 220.6 4.

g. when foreign investors were not yet allowed to purchase listed shares.8 48. legal lending limit. In 1988.5 333. Most banks therefore set up subsidiary finance companies to circumvent banking regulations.7 9. but dropped to 8 percent in 1991 when the Government tried to stabilize an overheating economy.5 1995 35.4 207. i.7 14. Overall. and consumer credit.6 859. credit cards.9 406.4 1996 1997 1998 50.6 310. the stock market has gained a bigger role in corporate sector financing (Table 1.7 15.6 91. 1992 1993 11. 1992-1999 (Rp trillion) Item Stocks Issued Outstanding (As % of Outstanding Bank Credit) Market Capitalization Source: Bank Indonesia.5 Financing by Finance Companies Finance companies first emerged at the end of 1980.1 18.7 percent in 1997. Prior to 1995. In 1995.2 16.e.6 301.3 percent in 1990 when the stock market was liberalized and foreign investors were allowed to purchase up to 49 percent of listed firms’ shares.1 1994 26.15). capital adequacy ratio. funds raised in the stock market were less than 5 percent of the credit disbursed by the banking sector. They were not. the activities of finance companies were not covered by regulations on prudential practices in the banking sector (e. It gradually increased again starting in 1991. limiting loans to a maximum of 15 times equity and foreign loans to five times the equity. factoring. shooting up to 18.0 206. 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 1996.9 1999 76. the Government issued regulations to supervise and promote prudential practices in finance companies. thus increasing the role of the capital market in raising long-term funds.15 Value of Stocks Issued and Stock Market Capitalization. During the 1990s.0 70. Table 1. finance companies were increasingly used as channels for the inflow of foreign loans.. The ratio reached 8.1 10.. . allowed to accept deposit accounts from the public.1 17. and net open position).Chapter 1: Indonesia 33 Some companies went public.0 15.6 123. offering services such as leasing. however.

0 1991-1996 16.3 16.5 11.2 Patterns of Corporate Financing Table 1. publicly listed nonfinancial companies had high proportions of equity and internal finance (retained earnings). Table 1.0 — = not available.6 12.4 13. Vol.4 8.0 1986-1996 17. Banks could invest only in commercial papers that were rated by the Indonesian Rating Agency (which was set up only in 1995 to rate debt instruments).6 100. . PACAP Research Center.16 shows financing sources of Indonesian publicly listed nonfinancial companies estimated by using flow-of-funds analysis. Thus in November 1995. at 81 percent of total borrowings. short-term borrowings were greater than long-term debts.7 22. they were not rated by a rating agency. In the second half of the 1980s. otherwise it would be classified as a loss in the banks’ books.0 3. In terms of composition.5 (0. II Commercial Papers Commercial papers.3 37.5 — 26. 1986-1996 (percent) Financing Source Internal Borrowings Short-Term Long-Term Debentures/Equity Debentures Equity Trade Credit Others Total 1986-1990 36.8 7.34 Corporate Governance and Finance in East Asia.8 17.6 23.3 14.5 percent and 36.6 8.3 (0. While banks had some exposure to these instruments. Source: Author’s estimates based on the Pacific-Basin Capital Markets (PACAP) Databases.4 23.0 39.16 Financing Patterns of Publicly Listed Nonfinancial Companies.1) 23. 1. respectively.5 21.8 percent.2 26. This is in contrast to the lower share of borrowings during the same period.0 100. which are unsecured negotiable promissory notes with a maximum maturity of 270 days. have been popular in Indonesia since 1990. 1996.4. averaging 26.1) 23.9 16.6 100. Bank Indonesia prohibited banks from underwriting issues of commercial papers but allowed them to act as paying agents.

6 trillion and Rp1. . Indofood registered losses of almost Rp1. the pattern changed. corporate debts accounted for 39. Two telecommunications companies.2 trillion (mostly foreign exchange losses). respectively. was due largely to a rapid rise in long-term debts.4 trillion in 1993 to Rp112. All companies in the cement industry suffered from foreign exchange losses. 1. Most corporate charters require commissioners to approve debt issues or sign debt agreements. that ownership concentration may be associated with heightened risk-taking by companies. also suffered from foreign exchange losses but managed to post profits of Rp0.1 trillion. the corporate sector’s high leverage.3 percent during 1991-1996. They also do not want to dilute corporate control and are more likely to finance growth with debt. The high share of equity financing was due to the surge in capital market activity following the 1988 reforms. with longterm debts increasing rapidly.2 trillion. Note that the corporate sector’s high leverage existed side by side with sizable equity capital raised from the capital market. These liabilities grew significantly because corporate expansion was largely financed by debt. Table 1. while Semen Cibinong’s losses reached Rp2. as evidenced by an average DER of 230 percent during 1992-1996 that rose to 310 percent in 1997. which was masked by the rapid growth in investments. The results indicate that firms with higher ownership concentration tend to have a higher DER.9 trillion in 1996.4.9 trillion. This amount doubled in 1997. Bank loans also surged when the banking sector was liberalized in 1988. Large shareholders are inclined to undertake risky projects intended to generate high returns using borrowed funds. Of the various financing sources. Indosat and Telekom. Many companies suffered big losses in 1997 due to their high exposure to dollar loans. The corporate sector invested heavily from 1991 to 1993 and slowed down its investment spending a few years before the 1997 crisis. Hence. The analysis of ownership patterns in Section 3 indicated that founders (the controlling party) or the five biggest owners held at least 50 percent of total shares.Chapter 1: Indonesia 35 In the 1990s. Corporate debts grew over time. reaching Rp229. which managed to post significant profits due to low exposure to dollar-denominated loans. in the context of Indonesia and some other countries.17 compares the DER of listed firms by degree of ownership concentration. except Semen Gresik (an SOC). rising from Rp54.3 Corporate Financing and Ownership Concentration It has been suggested. For instance.

36 Corporate Governance and Finance in East Asia. Source: Author’s estimates. the free capital flow system allowed private companies to borrow dollars offshore without any restriction. ultimately.0 1. As a result. Between 1987 and 1996. Table 1. heavy reliance of companies on bank credits to finance investments. aided . In addition.0 Notes: Firms with high ownership concentration have more than 50 percent of shares owned by the top five shareholders. decisions on debt are made with the implicit endorsement of owners. Controlling parties rely on external financing to maintain their equity share and. the private sector borrowed heavily in unhedged dollars. 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. Inadequate Financial Regulatory Framework Liberalization of financial markets increased the corporate sector’s access to domestic and foreign private capital.56 significant at the 10 percent level.5. the borrowings swelled. 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. The test of the difference between the two means found the t-value of 1.0 386. since commissioners represent the controlling party. 1.1 The Corporate Sector in the Financial Crisis Causes of the Financial Crisis Many intertwined factors led to the crisis. The low cost of foreign loans and the relatively stable exchange rate created a false sense of security for corporations.5 1. to maintain control of the company.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 699.358. Vol.0 351. II However. and high ownership concentration among families with political affiliation.

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

5 billion. or both. Collusion between big businesses and the political elite was widespread in Indonesia.5 billion was owed directly by corporations. $35 billion of Indonesia’s foreign debt owed to private foreign banks was about to mature in less than one year. They ensure that commissioners represent their interests and maintain close relationships with the chairperson. politicians. Aside from the fact that many of these loans were channeled through banks and corporations of politically connected families. contracts were granted to the private sector. and power generation) require huge capital. . In many cases. This fact was usually not disclosed in financial statements. where private banks are usually in the hands of big businesses. II By mid-1997. The ultimate control of the corporate sector rests in the hands of a small number of families who own groups of companies. partly because they used nominee accounts to register ownership rather than set up a holding company. there was also almost universal confidence that the economic growth would continue indefinitely. Vol. Corporations were certain that they could roll over short-term loans when these fell due. They enhance their control over companies through cross-shareholdings. toll roads. of which $64.38 Corporate Governance and Finance in East Asia. and in the process maintain control of the company. In early 1998. Families retain control by keeping the majority percentage of outstanding shares. There were cases where banks and borrowing companies were controlled by the same groups or families with strong political connections. as they had done so in the years before the crisis. Projects involving massive capital investments and long-term operating deals (in telecommunications. and investing shares among nonfinancial companies within the group and in other groups’ companies. total private sector foreign debt stood at $72. banks did not lend on the basis of the soundness of the project. Since the Government could not afford to undertake these projects. Family-controlled corporations were generally structured as a complicated web of affiliates and associated companies. by setting up their own banks. most often to people who were close to the ruling regime. This was often the case in the banking industry. High Ownership Concentration High concentration of corporate ownership (particularly by families) led to poor financing and investment practices. 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.

4) 2.8 1997 1.18 shows that growth in most sectors significantly fell in 1997.1) 1. Real Estate.6) (3. 1996-1999 (percent) Sector Agriculture. BPS).3 Source: Central Bureau of Statistics (Biro Pusat Statistik.0 5. Livestock. The JSX Monthly reported that total losses of 214 listed companies amounted to Rp39.Chapter 1: Indonesia 39 1.24 trillion for the first six months of 1998. and Business Services Other Services GDP 1996 3. Table 1.6) (0. The construction sector was the worst hit. 53 companies reported negative equity of Rp6.6 (36.0) 1999 2.7 6.8) (13. Forestry. The consumer goods industry reported the lowest ROE.2 (1. Only 86 companies reported profits. Most sectors showed significant increases in leverage. much higher than the 307 percent registered in December 1997.8 0.3 12. except utilities. as shown in Table 1.19. and Restaurants Transport and Communications Financial. This continued in 1998.9 3.6 13.5) (18.5.1 (1.1 6.6 8.4) (0.58 trillion (meaning their losses were greater than the paid-up capital).0 3. real estate. and 128 companies reported a total loss of Rp46.370 percent.4 7. indicating a rapid rise in .3 11.8 7. and Water Supply Construction Trade.0 2.2 8.4 7. Sectors with lower ROE generally had higher DER.2 Impact of the Financial Crisis on the Corporate and Banking Sectors Impact on the Corporate Sector Table 1. and Fisheries Mining and Quarrying Manufacturing Electricity.8 8.6 4.6 12. The average DER was found to be 1.1 5.7 1998 (0.8) (11.52 trillion.7) (8.4 5.18 GDP Growth by Sector. Using the financial statements as of 30 June 1998 of 161 publicly listed companies.0) (15. DER and ROE were calculated per sector. posted negative growth rates.7) 2. when all sectors. followed by property. followed by the finance and trade sectors. and building construction. Hotels.1) (26. Gas.7) (2.

2 23.5 percent in April 1998. Financial and banking analysts estimate that by September 1998.1 (124.3 7. Mostly suffering from a liquidity squeeze.4 5.0 229. 1996-1998 (percent) DER Sector Agriculture Mining Basic Industry Miscellaneous Industry Consumer Goods Industry Property Infrastructure Finance Trade/Services Average 1996 104.0 177. As the rupiah weakened and interest rates increased.19 DER and ROE of Publicly Listed Companies by Sector.7) 6.1 (5.0 205. Third.4 (6.0 219.9 12. .6) (115.0 12. This figure further increased to 47.0 111.2 13.8 17.6) 15. and would have kept on increasing if interest rates had not declined.0 1. private banks posted negative ROEs in the same year.7 1.1 (92.1) 7.5 8. the NPL ratio rose to 25.40 Corporate Governance and Finance in East Asia.0) 10.1 30.0 177.0 a ROE 1996 1997 1998a 14. Impact on the Banking Sector Table 1. a Actual data for 1st semester only.271.7 percent in July 1998. The huge losses suffered by most companies were caused by three factors. interest expenses rose as credit rates increased from 20 percent in early 1998 to 40 percent in mid-1999.1) Note: DERs were calculated for only 161 companies (out of 214) that had positive equity.4) 18.0 163. losses in operation were due to declines in sales and increases in the cost of imported inputs.395. small foreign banks enjoyed the highest profits.0 108.1 1.0 697. the NPL ratio had reached more than 60 percent.0 307. but annualized to approximate full year values.0 108.0 105. Second.370.0 97. as shown in Table 1.0 1997 234.0 193. First.0 2.2 (4.8 percent in 1996. from only 8.0 631.8) 36.0 92. The table also reveals that although private national banks dominated the banking sector in terms of assets and credits. Vol.0 72.21.0) (78. Source: JSX Monthly. rupiah values of dollar-denominated debts due to the weakening of the local currency and the rapid decline in equity because of losses.625.1 (3.8 (373.20 reveals that the banking sector’s ROE decreased significantly in 1997. II Table 1.0 65.6 (11.0 635.0 864.0 191.097.0 1.0 1998 186.2) (264.0 158.4) 8.0 1. foreign exchange losses came about with the use of unhedged foreign debt.0 2. several publications.

1992 7.0 622.07 1994 14. Source: The National Banking Association. July No.20 ROE of the Banking Sector.2 10.8 3.2 48.0 — 32.2 37.9 Regional Foreign and Development Joint Venture Banks Banks — 9.72 16. 230/1998.6 — 4.67 8.2 — 19.5 31.5 128.Chapter 1: Indonesia 41 Table 1.0 — 4.1 198.09 (11.43 10.6 6. 1992-1997 (percent) Type of Bank State-Owned Banks Foreign Banks Joint Venture Banks Regional Development Banks Private National Banks Total — = not available.84 27.2 1.5 2. 1996-1998 (Rp trillion) State-Owned Banks — 140.89 27.09 11. put pressure on the banking sector.9 297.37 19.5 34.9 11.45 21.9 percent.45 — 1993 15.30 5.5 57.7 4.4 7.6 — 13.3 445.1 30.86 11.12 15.7 29. Source: Infobank.21 Nonperforming Loans by Type of Bank.6 — 1. 227/1998 and October No.73 30.24 (4. private national banks overtook State-owned banks when their NPL ratio jumped to 57.69 14.34 16.68 1996 1997 8.2 47.50 9.7 — 1. coupled with negative spreads (deposit rate was higher than the credit rate). however.07 13.44 15.9 — 11.39 13.81 13.8 11.38) 11.0 129.3 22.3 Private National Banks — 179.2 — 8.15 20. In July 1998.91 21.8 14.70 1995 7. The high and increasing NPLs. .24 15.28 5.06 20. State-owned banks initially had the highest NPL ratio.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 331.2 8.2 8.7 106.20) Table 1.7 — = not available.8 187.8 8.25 22.1 1.1 274.1 47.1 13.5 222.47 20.3 361.

a number of prominent companies.5. 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. II 1.4 trillion of domestic debt and $6. However. the Government and private sector formed a committee to help corporates deal with the crisis. The scheme offered a hedging facility against rupiah devaluations for restructuring agreements. Another option that companies could take under the Jakarta Initiative was debt restructuring via debt-to-equity swaps. In addition. assembling the legal and policy framework to facilitate corporate restructuring. the Jakarta Initiative Task Force had conducted negotiations for 52 companies with Rp2.3 Responses to the Crisis Corporate Restructuring Measures At the end of 1997.7 percent ($64. The scheme encourages negotiation between creditors and debtors. none of the 2. The committee was tasked to ascertain the level of private corporate sector debts and arrange negotiations between debtors and creditors. and Ciputra (property business). the committee launched the Jakarta Initiative. Total amortization payments due on foreign debt in 1998 were placed at $32 billion (before restructuring). a more comprehensive scheme to tackle domestic and foreign corporate debt. Semen Cibinong (cement industry) became the first Indonesian company to resume paying part (25 percent) of the interest on its $1. such as Garuda (a national flag carrier). the scheme failed.7 billion of foreign exchange debt.42 Corporate Governance and Finance in East Asia. Vol. only a . Unfortunately.000 eligible firms had signed up for the scheme. 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. by mid-September 1998. By end-November.2 billion debt.6 billion) of Indonesia’s total external debt in March 1998. On 9 September 1998. Astra International (automotive). Aside from being described as overly complicated.000/$1) in debt from domestic commercial banks. companies were not servicing their debts. Since September 1998. the corporate sector had more than Rp600 trillion ($75 billion at Rp8. particularly in terms of debt resolution. While the process of restructuring was in progress. In November. have been subject to restructuring deals under the initiative. about 80 percent of which was private. few companies were in a position to resume interest payments. In June 1998. IBRA was formed to offer Mexican-style resolution for private sector foreign debt. Corporate debt accounted for 46. Thus.

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

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

The four state banks (BDN. merged. providing Bank Indonesia with substantially enhanced autonomy. improvement of rules and prudential regulations. was enacted in 1999. the Government required banks to be audited by international external auditors. BBD. the Government has drafted a regulation providing tax neutrality for mergers and removing other tax disincentives for restructuring. and follow-up action on bank restructuring.1 Summary. The importance of this legislation may need to be emphasized. Parliament approved amendments to the banking law that were geared toward strengthening the legal powers of IBRA and its AMU. Some 175 groups that originated from family businesses controlled . 1.Chapter 1: Indonesia 45 In 1997. The agency set up an Asset Management Unit (AMU) to directly manage problem loans of banks under its supervision. A new central banking law. and Recommendations Summary and Conclusions Corporate Ownership and Structure Most of Indonesia’s top conglomerates were established as family businesses. The merger process will be finished within two years. Bank Indonesia has announced a recapitalization program for potentially viable private banks. However. The Bank Indonesia 21st package includes recapitalization. the Government established IBRA to supervise problem banks. It has also drafted regulations to remove obstacles for converting debt to equity. Conclusions. In particular. 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. To overcome these problems. regulations will need to be issued to permit debt-toequity swaps in the context of corporate restructuring plans. and Bapindo) will be merged into one bank named Bank Mandiri.6. Other Regulatory Reforms To push corporate restructuring further. BEII. In October 1998.6 1. it is doubtful whether pure holding companies are able to enter into swaps. To obtain a clearer picture of the banking sector. Liquidity support given to troubled banks should be repaid in four years. depositors will be fully protected by the Government. Banks deemed ineligible for recapitalization will be closed.

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

corporate-initiated debt restructuring . To restructure the corporate sector. although at a declining rate.21 trillion in 1996. The financial crisis led to the closure of several dozen banks. Sales of conglomerates as well as those of publicly listed companies were increasing. it also reflects the failure of the financial sector to channel funds to the corporate sector efficiently due to weak prudential regulation and supervision.1 trillion in 1997 from Rp13. ROE dropped from 1. Net profits of publicly listed companies had consistently been growing at an average rate of 20 percent each year. At the height of the crisis.1 percent in 1998. Total profits of publicly listed companies dropped to Rp3. When the crisis hit Indonesia. the highly leveraged companies. Meanwhile.Chapter 1: Indonesia 47 without diluting their control. and registered a net loss of Rp39. The Government introduced reforms to improve bankruptcy procedures. The problem was in the maturity structure of its dollar-denominated debt and high debt-to-equity ratios in some sectors.1 percent in 1997 to -124.24 trillion in the first half of 1998. Impact of the Financial Crisis Prior to the crisis. financed by issuing nearly $80 billion worth of bank restructuring bonds. Responses to the Crisis The impact of the financial crisis on the corporate sector was serious. As the rupiah weakened and interest rates increased. Bank Indonesia extended emergency loans to many banks. the corporate sector was in quite good shape in terms of growth and profitability. The Government and the private sector responded with measures to mitigate the negative effects. the Government initiated corporate debt restructuring measures (Mexican-style foreign debt resolution and the Jakarta Initiative). the consumer goods industry was the worst hit. The significant increases in leverage indicate a rapid rise in the rupiah value of debts due to the revaluation of dollar-denominated debts.370 percent in 1998. the high domestic interest rates that prevailed from 1998. were the most adversely affected. particularly those with large short-term foreign loans. and the rapid decline in equity due to losses. On the other hand. followed by the property sector. and strengthen prudential regulations and supervision of the financial sector. DER increased to 307 percent in 1997 and further surged to 1. NPLs rose and capital adequacy ratios fell. facilitate debt restructuring.

48 Corporate Governance and Finance in East Asia. 1. and protecting creditors’ rights. 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. the regulatory environment was not prepared to supervise the increasing number of banks and nonbank . improving the legal and regulatory framework for bank supervision. Improving the Legal and Regulatory Framework for Bank Supervision After the liberalization of the financial sector. but inadequate protection to minority shareholders from the dominance of large shareholders. In particular.6.. and (iii) strengthening transparency and disclosure requirements. cost cutting and business consolidation) and acquisitions by creditors or foreign investors through debt-to-equity swaps and equity infusions. The Corporate Law should be reviewed and amended in the context of pervasive control by large shareholders. Specific recommendations include protecting the rights of minority shareholders. II measures included internal business restructuring (e. (ii) delineating the functions of the board of directors and commissioners. but it is not clear whether in practice these standards are in place. Vol. Protecting Minority Shareholders’ Rights The Corporate Law provides sufficient rights and protection for all shareholders. the legal system is less likely to evolve in a manner that will allow it to protect minority shareholders. The Government should ensure that all laws and regulations are effectively enforced. Most companies claim to have adopted international standards of accounting and auditing procedures. minority shareholders have not been able to oppose controlling shareholders’ decisions to invest in unprofitable projects financed by unhedged foreign currency debts.g. 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.2 Policy Recommendations The Government should introduce measures to address the weaknesses in corporate governance identified in this study.

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

despite the smaller level of capital inflows (as a percentage of GDP).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. Only when creditors have the confidence that their rights are protected will they resume financing companies. .

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

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. Korea) in November of that year. internal control mechanisms. Poor corporate governance and political and government intervention in the business and financial sectors are widely viewed as contributory factors. timely exit of poor performers from the market. Chung-Ang University. The country’s winners would then emerge based only on economic efficiency. the Government and business sector had good reason to reflect on the causes of the crisis. The authors wish to thank Juzhong Zhuang.1). 1 Professors. 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. As the Korean currency. . and curtailing of morally hazardous behavior that has been prevalent among economic decision makers. Department of Economics. or capital market discipline. Further. the Republic of Korea. Inefficient investment coupled with excessive financial leverage was found to be at the root of the economic crisis at the corporate level. and corporates were sent reeling. and Graham Dwyer for his editorial assistance. Chung and Yen Kyun Wang1 2.1 Introduction The economic crisis that began in Thailand and swept through Asia starting in the summer of 1997 hit the Republic of Korea (henceforth. Seoul. 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. a practice that was not checked by creditors. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. both of ADB. Business managers and controlling shareholders were maximizing firm size at the expense of profits. This has been the crux of the corporate governance problem in Korea. the Korea Stock Exchange for its help and support in conducting company surveys. It had been the norm in Korea to conduct business based on political and administrative favoritism rather than on competitive merits.2 Republic of Korea Kwang S. David Edwards. markets.

II Table 2. Weaknesses in the overall corporate governance system in Korea had many ramifications.1 Listed Firms with Positive Economic Value Added. aiming to identify the areas in need of further reform and to provide policy recommendations for improved corporate governance. which distributed and collected the questionnaire. Source: Korea Stock Exchange.9 1994 531 165 31. and improvement of bankruptcy procedures. and individual companies. especially chaebols. Restructuring efforts have focused on reduction in the degree of business diversification and in the financial leverage of large-sized firms.1 1998 490 164 33. where NOPAT is the net operating profit after taxes and WACC is the weighted average cost of capital multiplied by invested capital. This broad perspective can help clarify the ongoing reform efforts of businesses and the Government. Many firms left some questions unanswered.4 1993 513 174 33. 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. T. 1992-1998 Item Total Number of Firms Firms with Positive EVA Percentage of Firms with Positive EVA 1992 508 180 35. This study also reviews the legal and 2 The survey was conducted mainly through the Korea Stock Exchange. Government reform goals for the corporate sector include enhancement of corporate transparency. June 1999. Dividend payments were at less than 2 percent annually as opposed to the double-digit interest rates in the past decades. . The total number of respondents was 81 out of about 550 nonfinancial firms listed on the Exchange.54 Corporate Governance and Finance in East Asia. Koller. Vol.1 1996 561 163 29.1 1997 518 104 20.5 Note: The EVAs are calculated as: EVA = NOPAT – WACC. capital market discipline.1 1995 560 163 29. The EVAs are the same as the economic profit as explained in T. Inefficient investment undermined the competitiveness of Korean firms in the global marketplace. accountability of controlling shareholders and boards of directors. the corporate sector. and J Murrin (1995). Copeland. This study collects and analyzes data on the Korean economy. A survey was conducted for the nonfinancial listed companies using a questionnaire developed by the Asian Development Bank (ADB)2 to supplement official data.

Section 2. The evolution of the modern Korean economy can be divided into four periods. This chapter is composed of six sections.2.3 identifies characteristics of corporate governance by analyzing the ownership structures and control patterns of listed companies and the largest chaebols. and naturally adopted an import substitution policy. and employees and their role in shaping corporate governance practices. . the board of directors system.1 Overview of the Corporate Sector Historical Development3 The development of the Korean corporate sector is closely related to the progress of the economy. It reviews such elements as shareholders’ rights. the Government relied heavily on aid from the United States (US) and United Nations to alleviate poverty and high inflation. It then presents recommendations for further reform in corporate governance and financing. Section 2. It traces the country’s economic development.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.4 contains analyses of corporate financing and its relationship to performance.2 2. 3 The review of historical development of the Korean economy draws substantially from the book by Sohn. From 1948 to 1961.2. Major economic indicators for some of these periods are shown in Table 2. creditors. reviewing government policies responsible for the development of the modern corporate sector. Section 2. Yang. which account for a substantial portion of the Korean economy. and other necessities domestically. Section 2. The Government tried to produce food. In the period 19481961. 2. clothing. Section 2.Chapter 2: Korea 55 regulatory framework for the corporate sector and reform measures taken after the crisis. the import liberalization rate was below 7 percent and the average tariff rate was in the range of 25 to 30 percent. Import Substitution: 1948-1961 The Korean War (1950-1953) devastated Korea’s industrial capacity.6 discusses responses of the Government and the business sector and explains in detail their reform and restructuring efforts. and Yim (1998). corporate control by the Government.2 presents an overview of the corporate sector.

5) (1.5) 8. and implementing new budget and tax measures.4 29.9 — — 21.9) 1.8 24.102.6 11.2 314.2 757.265.8 12.8 (724. In the Plan. Export Drive: 1962-1971 Between 1962 and 1971. and inconsistent economic policies.9) (7.4 (1.2 452. IMF. the Government was not successful in solving the problems of slow growth. modernizing the industrial structure.4 10. b Refers to 1979. Source: Bank of Korea. 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.0 41.2 30.7 14.3 8. e For maturities of one year or more.7c 11.8 15.7 30.447. 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 1997.2 31.1 15.2 Key Macroeconomic Indicators Annual Average (percent.949.8 (8.753. c Refers to 1989.4 29.9 794. Economic Statistics Yearbook.2 6. This goal required very high savings and investment rates.4 24.855. a Refers to 1971.5 250. The Government tried . and large current account deficits.4 1990-1997 7. the Government redirected the policy focus away from import substitution to an export-led manufacturing-based economy. In 1961 it devalued the won from W65 to W130/dollar and announced its first Five-Year Economic Development Plan (1962-1966).1 percent with moderate rates of inflation and introduced a series of reform packages aimed at developing key industries.56 Corporate Governance and Finance in East Asia.7 37.0) 492.2 32.1d 9.0 27. Vol. largely because of political instability. lack of strong drive. II Table 2. high unemployment and inflation.0) (297.9b 15.2 1. the Government called for an unprecedented average annual economic growth rate of 7. However.1a 21.1 9.1 35. International Financial Statistics.5 38.1 29.1 — = not available.332.2 1980-1989 8.

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. . and almost doubled the foreign exchange rate from W130/dollar to W256/dollar to enhance the international competitiveness of exports. In 1963-1964. During the first five-year plan period.3 percent to 60. However. The average growth rate of the economy from 1960 to 1964 was 5. up from 30 percent in the late 1950s. but the average growth rate for 1965-1969 shot up to 10 percent.2 billion in 1972. abundant. and cheap labor force was well utilized by the export-led growth strategy. a modest improvement over the 4. the import liberalization rate was 55 percent. and maximizing mobilization of domestic savings on the other. These were considerably liberalized in 1967 when Korea joined the General Agreement on Tariffs and Trade (GATT).4 percent. while the average tariff rate was 39 percent. which laid a solid foundation for a steady growth path. imports of consumer goods and luxury items were highly restricted. The positive list system for imports was replaced with a negative list that indicated only those items that could not be imported. boosting internal investment resources. Bank deposits increased rapidly. due to continuous current account deficits. resulting in high real interest rates. The Government abolished temporary direct subsidy measures and introduced a new comprehensive export promotion system. but tariff rates were raised to 40 percent in the 1960s. During this period. The well-educated. But the liberalization trend turned out to be short lived as current account deficits continued. The exchange rate system was a kind of crawling peg until 1974. the Government undertook important economic reforms in two areas: the foreign exchange rate and the interest rate.3 percent average between 1954 and 1959. Exports increased sharply from $41 million in 1961 to $2. In 1971. Korea normalized political and economic relations with Japan to encourage inflows of Japanese capital that could finance big development projects. In 1964.5 percent. the Government tried to provide exporting firms with a free trade environment. This change raised the import liberalization rate from 9.Chapter 2: Korea 57 to meet its targets by borrowing large amounts of foreign capital on the one hand. the Government changed the multiple and fixed exchange rate system to a unitary floating exchange rate system. In 1965 the interest rate on one-year deposits doubled from 15 to 30 percent. the growth of gross domestic product (GDP) raised domestic savings. Also. channeling funds from curb markets into the banking sector.

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

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

2 Rise of the Large Business Groups (Chaebols)4 The Korean Fair Trade Act defines a business group as “a group of companies. giving up its foreign exchange controls related to the current account. Meanwhile. and declaring that it would follow Article XI of GATT.1 percent and average tariff rates 8. the Government committed itself to further liberalization of the goods and capital markets. In 1988.1 percent. which gradually widened. further increasing its pace of import liberalization.2 percent. . Vol. joined the Asia Pacific Economic Cooperation (APEC) Group in 1993. 2. By joining the Organisation for Economic Co-operation and Development (OECD) in December 1996. 46. Korea began participating in many multilateral trade negotiations during the Uruguay Round. In 1990. and total workforce.3 percent. Korea abolished remaining direct subsidy systems for export activities as well as some traditionally managed trade systems. Korea became a signatory country to the International Monetary Fund (IMF) Article VIII. whose business activities are controlled by an identical person. II world interest rates. Korea adopted a market average exchange rate system. total sales. The Government tried to adjust economic policies and regulations to meet global standards. where particular individuals and their family have de facto control of the management of all subsidiary companies of groups.” A large-scale business group is called a chaebol. In 1993. the importance of chaebols was increasing.2. The low value of the dollar led to a low won and high yen. 45. but it chose to liberalize gradually. with the 30 largest in the total economy in 1997 standing as follows: value-added.9 percent. and low oil prices.60 Corporate Governance and Finance in East Asia. total assets.9 percent. 47. in which the official rate for the day would be based on the interbank transaction volume-weighted average of rates of the previous business day. The 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). while continuous and large current account surpluses saved Korea from the foreign debt problem. 13. total debts. and acceded to the World Trade Organization (WTO) in 1994. Industrial and trade policies were modified to be consistent with WTO.9 percent. the import liberalization ratio reached 98. The most important element characterizing chaebols is the concentration of ownership. 4. The official rate fluctuated within a band.

Large-scale companies owned by the Japanese were sold to individuals under preferential terms and later enjoyed a relatively favorable position for accumulating capital.3 Source: The Fair Trade Commission. The Government provided subsidies. This galvanized the fast growth of chaebols. reaching 669 in 1996.3 shows that the number of subsidiaries of the 30 largest chaebols increased considerably since 1993.Chapter 2: Korea 61 War II.when the Government put a great deal of emphasis on development of the HCIs. and they are aided and supported by one another.3 Subsidiaries of the 30 Largest Chaebols.1 20. of Subsidiaries 604 616 623 669 Average No. 1993-1996 Year 1993 1994 1995 1996 No. Table 2. Table 2. the Korean Government has set the national goals of economic development and offered all kinds of support and incentives to achieve them. the ownership and management of a chaebol’s subsidiaries are not separate. This policy contributed greatly to the expansion of chaebols. . and tax breaks to key industries to promote exports and industrial upgrading. after the financial crisis. Since the 1960s. Chaebols are also excessively diversified. In the mid-1970s. One reason for this controlling power is inter-company shareholding among subsidiaries. of Subsidiaries per Chaebol 20. Subsidiary companies of chaebols are subject to “fleet-type management” in that they are controlled by the overall managerial system of chaebols. Since the Government controlled most business activities. From the standpoint of the Government. chaebols that maintained a close relationship with the political authorities were able to grow fast. it was more effective to deal with a small number of companies to secure tangible outcomes. financial assistance. large-scale businesses and chaebols were thought to be appropriate actors because they could meet the huge investment requirements of these industries. In this sense. The Government provided financial and fiscal incentives to chaebols and trading companies with relatively abundant financial resources. Important managerial decisions are made primarily by owners. Chaebols have a history of substantial concentration of ownership.5 20. However.8 22. the number of subsidiaries declined drastically due to corporate restructuring.

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

9 34.6 Year 1985 1989 1990 1994 1995 1996 1997 1998 Source: Monthly Review (Securities Supervisory Board) and the Financial Supervisory Service. 1985-1998 No. of Listed Firms 342 626 669 699 721 760 776 748 Stock Price Index 138.476 79.989 137. Second.4 654.1 Market Capitalization (W billion) 6.217 141.570 95. This reversal in policy reflected declining stock prices and was generally maintained until the outbreak of the economic crisis in 1997.4. the Government announced the gradual opening of the capital market to foreign investors in January 1981.798 Market Capitalization as a Ratio to GDP (%) 8. the Government announced measures to increase the demand for shares by providing tax and financial incentives to individual investors. mainly by increasing the supply of shares by initial public offerings (IPOs) and seasoned issues.1 16. 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. The policy to expand the size of the stock market. First. Third. Beginning 1990. several important policy measures were implemented to promote the development of the stock market.6 747. however. a country fund. the stock market grew rapidly during the 1980s.Chapter 2: Korea 63 During the 1980s and 1990s.0 49.2 44.. Because of government policies and the booming economy. 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). The aggregate Table 2.1 30.9 833. Inc. continued until 1989.7 934. The Korea Fund.4 40. in 1986 the Government imposed limits to bond issues on firms that were recommended to go public but refused. Also that year.5 406.370 70. especially those paying small or no dividends. In this regard.151 117.0 79.0 965. was established to invest in domestic shares beginning in September 1985. As shown in Table 2.020 151.4 Development of the Stock Market. . the Government attempted to stabilize the stock market by limiting IPOs and share issues by listed companies.9 918.

326 1.59 percent in 1998 and to more than 50 percent in the early months of 1999.352 471 3. and stayed at the 30-40 percent level up to 1996.001 4.546 (2. .126 (1.5 shows net FDI—inward investments by foreigners less outward investments by Koreans—in the period 1985-1998.2 percent by 1989. due to declining stock prices.650 (1.534) 1. but rose again to 34.239 19.149 13.008) (3.553 8.455) 13. Table 2. currency and deposits. The relative size of the stock market diminished to 44 percent in 1990.658) (3. Vol.953 10. Other investments include loans.858 4.800 (7. The reasons for the decline include increases in bankruptcies and mergers involving listed companies since the outbreak of the economic crisis.338 4. Table 2.694) 2.542) (1.924 (1.183 12. The growth in the number of listed firms also slowed in the 1990s.440 1.017) 1.414) 5.296) (6.942) 42.347 3.150 5.123 3. However.714 1.737 (333) (297) (607) (2) 218 2.583 25 10. Source: Balance of Payments. II market value of all listed firms represented only 8 percent of GDP in 1985.085 2.264) (3.141 4. and 1993.64 Corporate Governance and Finance in East Asia. The number shrank for the first time in 1998 to 748 firms from 776 the previous year.817 16.642 21. 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 1986-1989.287 (340) 73.868 (518) (418) 63 1.742 (3.870) (1.944) 8.433) (9. trade credits. 1985-1998 ($ million) Year Net FDIa Portfolio Investments Other Investmentsb Of Which Loans Trade Credits 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total a b 313 (9) 696 809 147 (808) (115) (311) (832) (2.5 Private Capital Flows to Korea.910) 2.382 Permit basis.785 (1.453 (2. foreign direct investment (FDI) has been very small relative to GDP and compared to other East Asian countries. Bank of Korea. and other liabilities.339) (9.86 percent of GDP in 1997.875 21.450 24.852) (2.571 2. The aggregate market value of listed shares bottomed at 16. but increased sharply to 79.500 7.255 2.413) 56.

and sales of the aggregate sector during this period were very high (Table 2. but between 1988 and 1993. but dropped in 1996 and were negative by 1997. portfolio investments amounted to $73. increased substantially in 1994-1996 due to accelerated liberalization of capital movements (Table 2. The ratio is generally in the same range for Japan and Korea. The debt-to-equity ratio (DER) averaged 311 percent for the period 1990-1996 and peaked at 424. Large amounts of outward investment by Koreans in the mid-1990s arose out of increased liberalization of foreign exchange regulations. The same categories will be analyzed in later sections. This would lay the foundation for evaluating the effect of corporate governance on performance. The dismal performance of the Korean corporate sector compared to the . the growth rates of equity and sales dropped sharply in 1996 and 1997. Corporate sector net proft margins increased from 1993 to 1995. The Aggregate Corporate Sector The aggregate corporate sector in this study excludes the financial sector. Korea had substantial current account surpluses and experienced net private capital outflow. and (iii) chaebols. and US. The growth rates of total assets. following the sharp depreciation of the won. This indicates that a substantial proportion of debt was denominated in dollars. weak incentives for attracting FDI. excluding FDI.9 billion. other net private capital inflows amounted to $130 billion during 1985-1998. Japan’s was consistently higher.7 compares the ratio of ordinary income to sales of Korea’s manufacturing sector with those of Japan.6).China.4 Growth and Financial Performance This section looks at the performance of (i) the aggregate corporate sector. Of this.7 billion and loans $42. 2.5). Net private capital inflow. However.China and the US.2. The contribution of the corporate sector to GDP was 73.6 percent in 1997. In addition to FDI.Chapter 2: Korea 65 Complicated government regulations. Profit rates of Korean firms were relatively low compared to those of Taipei. (ii) listed firms.2 percent in 1987. Table 2. Return on equity (ROE) and return on assets (ROA) showed similar patterns. equity. Between 1986 and 1989. Taipei. and high production costs were the main reasons for low FDI in Korea. increasing to 76 percent in 1997.

. Financial Statement Analysis Yearbook.0 3.3 1.0 6.9 13.9 3.6 424.6 1.9 4.2 18.9 2.7 4.2 1.4 2. Table 2.6 2.9 5.3 335.8 8.4 2.1 2.3 14.2 13.7 International Comparison of Ratios of Ordinary Income to Sales in Manufacturing (percent) Year Korea US Japan Taipei.5 7.1 2.5 1. Ordinary income = operating income + nonoperating income (from financial activities) – nonoperating expenses (from financial activities).1 6.4 1.6 (4.4 — 6.2 9.9 16.5 2.8 21. Source: Bank of Korea.8) 297. Financial Statement Analysis Yearbook.9 2.4 4.7 2.0 10.7 15.5 1.3 312.1 — — — = not available. Source: Bank of Korea.8 1.0 7. Net profit margin = ratio of net income to sales.5 (0.6 9.8 1.5 4.2 1.1 8.7 15.0 0.9 16.7 3.3 6.China 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 2.9 5.4 1.3 11.2) (0.3 21.9 5.0 (0.0 8.9) DER = debt-to-equity ratio.6 4.9 18. 1990-1997 (percent) Growth Performance Year Total Assets Equity Sales Financial Performance Net Profit Margin DER ROE ROA 1990 1991 1992 1993 1994 1995 1996 1997 23.2 13.8 2.3) 5.4 2.3 21.Table 2.6 1.7 325.6 3.3 17.5 4. Note: Ratio of ordinary income to sales = (ordinary income/sales).1 2.3 308.0 305.2 19.8 22.7 3.5 3.9 2.9 8.1 5.2 1.0 13.9 3.5 1.5 0.0 13. ROA = return on assets (ratio of net income to total assets).6 Growth and Financial Performance of the Nonfinancial Corporate Sector.3 — 3. ROE = return on equity (ratio of net income to stockholders’ equity).4 1.9 18.3 3.7 1.7 4.0 4.4 19.7 4.6 318.6 13.8 3.4 10.

However. sales of listed firms grew 18. Growth rates of total assets are generally high. the average ROE was lowest for large firms. and transport sectors recorded negative profit rates in 1997. the sales growth of listed firms was higher than that of the aggregate sector (see Table 2. All sectors experienced a sharp decline in equity and sales growth in 1997. The profit margin of listed firms was generally higher than that of the aggregate corporate sector. This preference of Korean firms has its roots in the structure of corporate governance.4 percent. trade.5 percent while the aggregate sector recorded only 13. Again. The other financial ratios follow the general pattern of the aggregate corporate sector. Net profit margins. The manufacturing. construction.Chapter 2: Korea 67 other three economies can be attributed to the emphasis on growth in sales and market shares rather than on profits. In 1997. but higher than that of small firms. while their average net profit margin was lower than that of medium firms. This may be related to its having the lowest DER. 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. Listed Companies The number of listed firms increased from 334 in 1985 to 775 in 1997 (Table 2. this may be an indication of the bias toward large firms in terms of access to credit. 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. In most years. both ROA and ROE were lower for the listed firms compared to the latter. . and steam supply industry. It is notable that the construction sector’s profit rate began its decline in 1995. followed by mediumsized firms and large ones.8). ROEs. Profit rates of different industries also mirrored the downward trend of the aggregate corporate sector prior to the crisis. gas.10). However. the exception being the electricity.6). Profit rates of most industries are also quite low. a year ahead of the other industries. Performance followed similar patterns across different industries (Table 2. with the wholesale and retail trade sector and the construction sector having the highest figures. Small listed firms were hardest hit by the financial crisis. and ROAs of all listed firms declined substantially in 1996 and turned negative in 1997.9).and small-scale firms (Table 2. with equity in wholesale and retail trade even contracting.

6 11.5 432.5 569.1 (0.0 1.0) 0.3 31.7) 2.1 10.7 514.0 (4.0 3.9 3.1 21.2 315.8 12.6 318.1 396.9 538.9 340.6 12.7 4.4 2.8 0.8 16.8 12.1 0.5 286.9 5.9 13.2 423.3 2.9 14.0 1.3 1.0 5.3 14.4 740.5 19.8 1.2 (1.4 5.7 317.7 16.6 2.8 3.8 461.4 17.6 14.5 13.0 2.0) 1.3 11.6 655.1 22.4 10.8 616.5) 0.3 1.1 16.8 16.9 29.4 2.8 526.4 0.2 5.8 2.4 10.4 0.6 6.0 37.4 1.9 10.0 21.9 2.5 (1.0 16.2 0.1 296.8 24.1 2.5 28.5 16.1 (0.8 14.7 5.0 24.9 16.6 16.4 348.9 16.2 5.0 1.9 2.3 13.5 1.5 23.8 24.4 10.7 30.9 16.0 (0.1 17.8 1.1 1.7 7.2 36.0 18.7 228.8 562.0 1.4 2.6 7.2 6.0 15.5 1.5 1. Renting.2 24.9 31.4 10.8 0.7 10.8) 0.3 11.0) 4.8 345.3 15.2) (0.4 3.3 15.1 290.5 1.0 7.4 (0.3 285.5 27.5 5.3 2.8 3.9 1.9 25.6 17.2 16.0 24.2 0.0 5.4 474.0 22.5 30.7 (0.2 6.3 15.3 25. and Business Activities 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 11.4 2.5 1.1 7.8 16.9 9.2 15.0 22.0 15.3 288.0 22.4 4.3 15.8 2.4 2.0 19.1 1.1 1.7 1.7 22.Table 2.8 13.1 28.9 19.6 15.6 17.5 14.5 3.5 270.2 5.8 Real Estate.6 14.2 0.7 (3.2 12.6 0.0 9.6) (6.7 0.5 473.4 5.2 18.9 (0.3 18.0 254.7 21.5 (5.5 239.1 1.3 8.4 350.4 291.1) 0.0 18.0 (0.0 2.8 2.0 16.0 1.9 10.8 10.2) 22.7 17.6 1.4 .4 1.2) 15.4 12.5 4.3 8.6 12.7 9.5 6.1 27.5 6.1) (3.8 22.4) 0.4 5.6 3.8 23.8 17.8 32.8 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 13.2 20.6 24.1 20.5 (0.6 5.3 10.9 (0.6 3.2 16.5 306.0 245.2 241.5 483.8 7.6 375.3) (1.3 14.4 458.0 2.5 5.2) 6.8 35.0 1.4 15.8 22.3 8.8 302.1) 3.9) 1.0) 0.6 14.9 0.6 0.0 23.5 338.1 2.8 34.5 1.2 7.4 9.7 520.0 12.6) 3.7 294.8 10.8 14.5 Construction 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 18.3 10.0 2.1 0.0 1.6 1.1 0.4 14.9 428.9 (0.3 8.2 20.2 25.2 2.

4 3.4 — — — — — 448.2 698.5 26.2 11.1) (0. Financial Statement Analysis Yearbooks.6 4.6 2. .5 15.4 2.2 10.4 2.0) 1.7 11.8 4.6 (2.1 6.6 12.6 6.4 14.8 529.7 12.6 15.8 0.7 116.4 (2.6 8.2 — — — — — 2.8) (12.5 344.4 367.3 524.3 9.5 11.6 12.3 2.8 3.8 6.1 14.4 12.7) (4.6 (2.9 (10.5 14.1 17.1 16.5 482.4 633.6 14.0 5.4 21.7 19.7 14.3 112.2) 0.9 6.8 12.4 1.9 (11.3 0.0 13.0 89.0 921.7 20.0 14.0 98.4 11.7) 0.3 12.5 14.6 9.5 612.5 462.2 2.7 15.8 7.8 8.0 2.3 17.6 512.6 8.2 14.1 15.1) (0.3 18.3 740.3 4.6 34.3 3.6 9.1 12.9 10.0 1.4 15.6 — — — — — 0.9 4.6 20.7 11.9 17.4 3.7 11.4 7.0 1.1 21.8) 1.3) 11.3 1.3 23.1 3.8 6.0 106.7 2.4 13.3 8.2 18.6 18. a New equity does not include capital surplus. Source: Calculated using data from Bank of Korea.9 18.3 543.8 15.4 16.5 13.2 10.3 125.9 12.0 14.8 12.6 9.1 (11.5 117.3 1.3 4.9 3. and Communication 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 15.2 18.7 7.6 3.5 11.2 18.1) 1.6 — — — — — 17.6 19.6 19.8 (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 — — — — — 31.9) (8. and Steam Supply 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 12.1 (0.5) 22.1 1.2 143.4 169.4 12.6 6.3 0.4 9.0 (15.9 18.5 47.4 0.2) 13.1 8.8 11.2 10.0 Transport.3 4.7 2.2 90.0 5.6 4.9 8.5 14.0 (1.5 12.8 0.1 11.4 1.Table 2.5 16.3) (1.7 16.8 9.1 2.2 15. Storage.6 6.4 30.1 11.4) (1.7 7.3 19.2 122.8 111.5 8.4 3.5 30.4 1.3 34.4 0.2) 9. Gas.9 1.3 8.6 16.9 9.1 (2.9 9.6 1.9 456.3 18.9 332.7 187.7 0.8 14.2 7.3) 15.5 539.0 21.5 14.0 1.3 — — — — — 10.9 Electricity.9 7.3 (2.8 14.1 15.4 7.3) 4.2 3.2 1.1) 5.7 0.5 2.1 15.9 17.8 3.1 4.9 4.7 — — — — — 14.4 6. b NPM denotes net profit margin.9 321.7 — = not available.5 15.0) (0.4 10.5 4.4 6.6 0.6 21.6 8.7 510.1 323.5 0.2 14.5 307.4 0.0) 1.062.4 (0.6 1.4 341.6 172.0 2.9 8.0 7.9 10.9 12.5 (2.

3 2. the growth of sales of the top 30 chaebols exceeded that of the aggregate corporate sector (compare Tables 2.6 0.9 percent).9 21.0 0. In 1997. The number of Hyundai member companies rose to 57 in 1997. the largest chaebol.7 1.3 0. unless otherwise indicated) Financial Performance Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average No.9 Source: Constructed using data from Korea Investors Service. Performance of Chaebols This section uses available data on the top 30 chaebols.9 0. The smallest group had 16 members in 1995. of which 16 were publicly listed (Table 2.6 23.3 (0.3 20.5 ROE 3.1 1.9 2.9 11.7 (5. Between 1993 and 1997. The criteria for selection of largest chaebols have changed a few times. it is the chaebols’ large firms that are listed.8 5. the top 11-30 chaebols experienced a decline of . Chaebols have been the most important actors and engines of growth in the Korean economy.9 26.2 9. Kis-Fas.2 0. had 46 member companies.7 1.11). followed by the top 6-10 (Table 2.5 0.5 ROA 0. the 30 largest chaebols accounted for 13.0 18.2 6.2 2.12).9 2.4 1.8 24.6 22.5 19.8 0.7) 0.3 4. It should also be noted that when the financial crisis struck in 1997. II Table 2.9 percent). In 1995. Hyundai Group.1 percent of the economy’s total value added (excluding the financial sector).1 6.12).2 9. sales (45.4) 1.9 1.9 Growth and Financial Performance of Listed Companies.4 2.7 percent) of the corporate sector. 1998. and close to half of total assets (46.7 Net Profit Margin 0.6 and 2.6 (1.6 1.70 Corporate Governance and Finance in East Asia.9 6. Vol. debts (47.5 5. but the number of designated groups has been fixed at 30 since 1993.1) 4. The top five chaebols registered the highest growth rates.3 percent). 1985-1997 (percent.6 2. of which four were listed.4 0.6 3.5 19.3 15. Generally.8 6.4 22.1 1. of Firms 334 351 386 503 626 669 680 681 687 698 715 754 775 Sales Growth 10.0 3.4 1. and net profits (46.4 1.

0 19.6 (0.6 2.2) 0.0 1.3 Medium 14.8 1.9 (0.4 3.9 0.8 0.2 0.2 Small 13.4 1.9 2.8 0.9 25. 1988-1997 (percent) ROE Large 9.7 (0.0) 0.9 22.8 6. 1998.4 16.7 2.6 7.4) 1.0 1.0 16.5 Net Profit Margin Year Large Medium Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 2.5 5.4 6.2 3.3 11.5 5.4 1.2 13.3 6.8 (5.10 Growth and Financial Performance of Listed Companies by Size.9) (6.3 1.3 3.0 (4.0 15.4 11.3 15.2 2.6 9.1 11.9 0.8) 6.9 2.4 2.2 Note: Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.8) 1.7 4. Kis-Fas.7 2.9 2.3 9.2) (1.6 0.9 5.2 7.7 1.6 (1. Others are medium firms.0 1.6 1.7 (1. .5 3.0 10.2 (0.2 12.7 (1.8 0.6 13.1 2.8 16.9 3.8 17.1) 5.6 1.5 1.5 25.9 6.5 17.9 1.1 0.3) 5.6 5.0 6.4 5.7 3.5 (1.0 17.5 0.6) 0.5) 1.2 10.3) 0.0) 1.6 8.6 1.6 3.2 13.0 1.2 1.1 2.Table 2.9 14.4 3.3 15.2 2.6 0.2) (1.3 (0.1 8.1 1.3 (0.7 18.8 3.6 3. Source: Korea Investors Service.8 6.9 6.0 4.8 10.9 1.5) 1.4 Medium Small Large Medium Small ROA Growth Performance Large 17.6 6.9 0.8 0.5 2.6 2.6 2.8 7.

501 13.853 1997 53.309 14.756 5.395 31.117 4.640 4.924 2.427 9.967 7.303 3.457 14.995 2.129 2.599 — 2.287 10.158 1.158 7.313 14.090 6.147 5.376 35. .798 — No.990 2.761 31.180 2.364 5.935 2.743 40. 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.131 3.873 2.370 6.177 — 6. Source: Fair Trade Commission.458 6.766 3.346 3.690 3.996 1.956 3.475 2.774 7.455 22.597 351.398 — 2.951 3.Table 2.910 3.929 12.651 38. 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.677 3.486 6.927 16.574 3.11 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 43.246 11.423 5.433 3.445 4.

5 5.9 20.3 27.6 25.7 10.2 1.9 1.2 0.9 3.4) (14.7 1.4) 1.1) 0.9 18.4 30.4 38.2) 1.1 10.1) 0.6 (0.7 15.6 1.8 27.0 2.0 1.3 0.1) (0.5 27.2 (2.5 20.2) (2.7 0.9 17.5 (0.6 Financial Performance Net Profit Margin 1.3 15.9 24. .2) (0.8 Assets 12.3 3.3 14.0 31.1) (1.9 20.3) 0.6 18.8 18.1) (0.0 2.1 (1.Table 2.2 (2.4 (2.3 19.3 1.5) (0.7) ROE 5.7 13.1 (2.1 19.4) (0.7 10.7 4.5) (0.7) Source: Bank of Korea.0) 12.3 16.2 0.8 0.0 6.1 2.2 20.0 0.12 Growth and Financial Performance of the 30 Largest Chaebols.6 19.4 12.2 (5.0 19.1 27.0) 3.2 0.5 32.3 9.3 0.0 17.5 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 12.5) (0.3 11.0) ROA 1.6 4.7 15.2 3.2 11.2 (16.3 1.0 2.1 (3.0 0.9 3.5 2.4 0.4 26.

However. II 2 percent in their sales and a very low 4. The absence of a well-developed equity market and the provision of subsidized credit.” This “identical person.765 percent (Table 2. from 190 to 3. The ROE of the top 30 chaebols was consistently higher than that of the aggregate corporate sector.3. There has been a wide range in DER among chaebols. a pyramidal structure of corporate ownership is prevalent. and the companies that are under the control of the largest shareholder. Only the top five chaebols registered a positive net profit margin in 1997. the net profit margin of the aggregate sector exceeded that of the top 30 chaebols.74 Corporate Governance and Finance in East Asia.3 Corporate Ownership and Control This section looks at the key aspects of corporate governance in Korea. In general.13). technology. 5 While “ownership concentration” can be defined and measured differently in different contexts. resulted in the chaebols’ excessive leverage.1 Patterns of Corporate Ownership The ownership of most Korean listed firms is highly concentrated. loopholes and inconsistent policies spawned strategic behavior and agency problems. his/her relatives. Vol. the average DER of the 30 largest chaebols reached 519 percent. The Commercial Code stipulates the basic governance framework and applies to all corporations. weak corporate control. in this instance. 2. . Ownership patterns. and access to credit. coupled with weak corporate governance. and vulnerable balance sheets. chaebols had a higher average DER than the corporate sector as a whole. 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.7 percent growth in total assets. The better showing of the top five chaebols was a direct result of their dominance in human resources. and government intervention interacted through a set of laws and regulations to bring about the existing structure. internal and external control mechanisms. more important. Their worst year was 1997 when ROE hit -15. includes the largest shareholder. it refers to the degree of concentration and shareholdings in the hands of an “identical person.95 percent.5 Founding families are mostly still the largest shareholders and. By the end of 1997. 2. and led to a high concentration of ownership. However. The financial performance of the top 11-30 chaebols deteriorated during 1993-1997.” in Korea’s legal and regulatory framework. except for 1995.

7 620.0 218. Kia 9. Hanwha 10.6 409.441.7 354. Jinro Debt-to-Equity Ratio 376.3 328.1 385.3 572.1 477.8 312.065.0 506. Kumho 12.5 337.2 292. Lotte 11.4 622. Dongah 14. LG 4.7 688.855. Daewoo 5.3 297. Samsung 3. Kukdong Construction 29.4 192. Lotte 11. LG 4. Hyundai 2. Dongkuk Steel 19.4 205. Daelim 14.1 190. Kohap 25.9 751. Hyundai 2.764. Hyosung 18. Dongah Construction 16. Kumho 12.9 321. Ssangyong 7. Haitai 26. Hanjin 8.3 315.8 313.6 .13 The Top 30 Chaebols’ Debt-to-Equity Ratio.2 2.0 486.5 2. Halla 13.244.1 3.6 516. Hanil 28. Daewoo 5. Tongyang 22. Sammi 27.7 621.7 267. Dongkuk Steel 19.6 936. Sunkyung 6. Sunkyung 6.4 175. Kia 9. Samsung 3. Ssangyong 7.0 436.Table 2. Byucksan 1996 1. Kolon 21. Newcore 30.5 383. Dongbu 24.2 471. Halla 17. Hyosung 18.7 416. Hanjin 8.0 370. Hanbo 15.2 346.2 924. Doosan 13.2 328.2 423.6 2. Doosan 15. Hansol 17.5 3.4 556. Hansol 23.5 464. Hanwha 10.5 343.1 674.8 336.1 278. Daelim 16. 1995-1997 (percent) Chaebols 1995 1. Jinro 20.

5 (893. Shinho 26. Tongyang 24. Lotte 12.5 519.9 472. LG 5.8 468. Miwon 30.0 419.6 424.7 370.1 359.9 465.5) 404. . Dongbu 23.13 (Cont’d) Chaebols 20. Shinho 1997 1. Keopyong 29.1 472. Hanil 28. Hansol 16.5 323.0 907.0 505.1 433. Newcore 26. Halla 13. Haitai 25. Dongkuk Steel 20. Jinro 23. Kolon 21.6 416.9 1.5 (1. Ssangyong 8. Hanwha 9. Hyosung 17. Kohab 18.9 216. Hanjin 7.5 386. Dongbu 21.8 647.7 1.3 347.8 338.9 578.8 399.8 307. Saehan Average of All Chaebolsa 1995 1996 1997 Average of All Industries Excluding Financial Sectorb 1995 1996 1997 Debt-to-Equity Ratio 317.600. Keopyong 29. SK 6.8 347. Kamgwon Industrial 30.6 335.214. Kolon 19.8 590.4 1. Financial Statement Analysis Yearbook.498.9 490. Daelim 14. Daewoo 4. Anam 27. Kohab 22. Hyundai 2. Tongyang 24.6 590. Doosan 15.501. bBank of Korea.1 375.0 305.5 576.3 399. Dongah 11. Newcore 28. Anam 22.3 1.5 1. Samsung 3.4) 513. Kumho 10.5 261.7 944.Table 2.6 Sources: aFair Trade Commission.225.784.3 676. Haitai 25.6 478. Daesang 27.1 438.8 658.

However. the extent of ownership by these individuals declined gradually after 1988. Composition of Ownership Among listed companies. 10 to 30 percent). Financial institutions owned as much as 28 percent of the total corporate shareholdings in 1992. and then steadily declined after 1993. but their shares declined to 21. resorting to extensive use of pyramiding to maintain control. managerial entrenchment becomes more likely.” foreigners. the year the stock market was in a frenzy due to buying sprees. and state-owned companies and securities companies declined.Chapter 2: Korea 77 When controlling shareholders hold a very small percentage of the shares. the percentage of holdings by individuals slipped to 60. Securities companies reduced their holdings over this period of falling stock prices as the size of investment trust companies’ stock portfolios declined. The pattern of distribution changed little through 1992-1997. large ownership can also bring about the entrenchment effect. the incentive effect once again dominates. Among listed nonfinancial companies. i.6 percent by 1997.” followed by banks. the entrenchment effect outweighs the incentive effect. the entrenchment effect and problems of agency may be more pronounced in chaebols than in independent firms. that is. fluctuated widely during the period. the Government. When managerial holdings are reinforced by artificial control mechanisms such as pyramiding. Thus. Beyond that range. the individual owners—the portfolio investors as well as the controlling shareholders and their family members—formed the largest shareholder group (Table 2.7 percent by 1997. and insurance companies increased during the period.14).1 percent. an increase in their ownership may bring their ownership incentives to converge with those of the minority shareholders. while those owned by banks. From 69. The percentage of shares owned by “other corporations. individuals were also the largest shareholder group. The controlling shareholders of chaebols hold comparatively smaller percentages of shares. Theoretically. an entrenched manager is insulated from market pressure and can pursue personal goals without the fear of being replaced. However.e. The reduction can be . including investment trust companies. Most non-chaebol listed firms in Korea are believed to have ownership concentrations within the 10-30 percent range. The next important group was “other corporations. including banks and other financial firms. the ownership structure can bring about an incentive effect. with a given range of managerial shareholdings (for instance. The holdings of financial institutions..

2 B.6 36.3 17. d Constructed from data files of the Korea Listed Companies Association.0 27.5 18.1 21.5 7.0 9.3 1996 570 2.4 13.2 1.4 14.3 5.1 60.8 17.7 9.1 1.0 5.4 5.9 1.2 8.9 37. .6 19.1 8.6 16.9 5. mutual savings. Listed Nonfinancial Companiesd 1988 406 0.1 18.8 1995 548 2.6 8.8 5.2 8.2 17.0 59.9 17.5 4.5 6.8 4.9 19.1 8.8 69.7 6.” includes commercial banks.2 9.6 16.7 8.9 2.4 13.9 2. of Firms The Statea Banks. a The State covers the Government and state-owned companies.3 5.9 26.6 Year No.5 1992 508 2.0 5.5 62.2 4. etc.7 59.4 Insurance Firms Other Corporations Foreigners Individuals 39.3 26.4 34.5 7.5 6.3 18.2 9.2 5.3 18.2 1993 511 2.8 2.7 4.7 1990 531 0.9 36. investment trust companies.0 7.4 1997 551 1.5 1.Table 2.3 2.8 5.6 12.0 4.6 2.6 22.3 1994 521 1.0 8.5 1989 498 0.8 17.4 5.3 1.2 2.6 9.1 18.7 14.2 3.4 18.5 1.5 12.1 17.1 11.2 7.b A.5 Note: Ownership is based on number of shares.3 17.2 18.6 13.6 9.1 3. All Listed Companiesc 1992 681 1993 687 1994 698 1995 715 1996 754 1997 775 9.6 20.0 28.7 7.8 2. c Data from Korea Stock Exchange.5 16. b “Banks.6 1991 505 0.3 8.9 15.7 18.1 2.2 5.0 60.14 Ownership Composition of Listed Companies.7 9.9 4.4 6.7 3.9 1.3 1.1 68.8 59.1 4.5 60.1 10.3 39. merchant banks. and finance companies. 1988-1997 (percent) Financial Institutions Securities Firms Total 28.1 21. etc.8 59.6 16.

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

4 — 0.0 9.2 54.4 2.3 1.5 0.6 1.4 8.0 8.9 1.5 — 0.7 63.2 0.3 0.4 Banks.5 85.1 8.8 7.0 1.0 Industry 1990 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.7 20.4 1.4 5.4 56.5 7. Rubber. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.0 9.9 19. Motor Vehicles Electricity.0 20.7 1.9 4.7 17.5 17.5 19.8 7.3 2.9 8.1 4.2 9.3 7.1 10.7 14.4 1.5 6.1 7.2 0.9 15.1 27..4 8.8 73.6 — — 2.1 0. Elecl Mach.9 59.3 11.7 20.0 — 39.0 — 0.1 1.1 8.8 8.5 0. and Printing Chemicals.9 23. Paper.7 6.1 65.2 64. 1990 and 1997 (percent) Financial Institutions The Statea — — 0.0 10.2 1.1 0.3 0.3 9. Etc.1 0.2 7.6 18.7 22.5 3.3 57.5 — — 0.1 19. and App.2 — — 0.8 7.7 64.3 62.4 8.0 9.7 2. and Printing Pulp.2 9.7 29.8 3.3 10.2 17.4 7.15 Ownership Composition of Listed Nonfinancial Firms by Industry.5 4.4 56.9 55.7 2.9 66.9 10.8 3.6 3.Table 2.3 13.4 0. Gas.9 1.7 2.9 16.b Securities Firms Insurance Firms Other Corporations Foreigners — — 0. 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 .7 59.3 1.8 6.8 Individuals 83. Paper.2 — 0.2 9.3 0.8 5.5 0.9 60.8 7.2 22.5 12.0 7.6 11.6 24.7 22.2 0.3 2.6 5.0 9.9 0.3 38.8 1.2 0.4 14.1 88.2 2.3 4.9 52.7 14.6 8.5 0.4 62.8 7.2 1.9 42.0 2.5 — 1.1 0.3 6.0 0.

4 1.2 8.9 1.2 5.5 3.8 5.9 1.8 2.8 6.5 3.4 68.8 2.8 2.5 4.1997 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.9 1. etc.2 5.0 11.6 0.9 2.9 18.1 3.1 9.5 0.4 6.4 9.4 4. investment trust companies.6 2.7 17.8 3. Paper.1 3.5 59.2 4.2 1. merchant banks.6 5.9 6. b “Banks.7 2. Motor Vehicles Electricity.9 20. mutual savings.8 12.2 49.5 5.7 4.6 18.5 3.3 6. Gas.9 57.1 2.2 4.3 31. and App.4 43. and Printing Chemicals.4 45.6 60.1 54. and finance companies.4 16.6 0.8 5. and Printing Pulp.4 — 1.1 9.2 0.1 18.1 — 0. a The State covers the government and state-owned companies.9 78.6 3.5 — 2.1 1.4 2.2 4.2 4.4 58.3 8.4 76.” includes commercial banks.6 6.5 4.4 1.1 4.8 11.9 0.3 60.1 25.8 54.6 14.4 2.9 20.0 6.3 1.9 7.8 0.4 4.9 2.4 2.78 81.0 3.2 7.8 0.3 15.8 27.4 3.7 1.7 23.2 3.3 2.1 2.5 6. Source: Constructed from data files of the Korea Listed Companies Association.0 1.4 58.4 0.6 — = not available.7 5.2 6.3 7.2 1.9 2.9 6.6 2.9 69.2 13. Elecl Mach.6 59.0 4.3 6.7 2.1 1.0 5.8 57.6 75.1 — 1.1 6.6 6.5 7.8 4.6 2.6 20.5 63.4 1.3 65.9 5.2 0.0 6. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.0 60.7 19.6 7.0 8. Rubber. Note: Ownership is based on number of shares. . Paper.3 1.0 7.7 2.7 2.3 57.7 6.9 5.5 12. 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 1.2 23.5 3.5 1.9 7.0 43.9 2.6 1.3 0.4 20.

17 Ownership Composition of Listed Nonfinancial Firms by Control Type. investment trust companies.9 2.4 2. Source: Constructed from data files of the Korea Listed Companies Association.7 0.8 60. of Firms Independent Firms Affiliates of 30 Largest Chaebols Total 316 117 433 Source: Constructed from data files of the Korea Listed Companies Association. 1997 (percent) The Stateb Foreigners 4.5 19.4 Firm Sizea No. The State covers the government and state-owned companies.Table 2.7 Control Type No.1 2.4 17.9 5.0 Other Corporations 16.7 1.16 Ownership Composition of Listed Nonfinancial Firms by Size. and finance companies.8 4. 1997 (percent) The State 1. etc.1 6.2 1. Securities Firms Insurance Firms 2.4 5.1 Banks.8 4. mutual savings.8 6.4 61.4 1. etc.8 1.5 2. .” includes commercial banks. b Table 2.4 2.0 1.4 4. Others are medium firms.0 6.4 61.5 62.3 Banks.6 60.7 6. etc.4 5.7 Foreigners 4.5 Individuals 60. merchant banks.4 21.5 4.7 8.7 4.9 4.8 2. c “Banks.3 6.5 8.1 8.5 6.6 16.5 18.8 3. of Firms Large Medium Small Total 211 208 80 499 a Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.5 16.c Securities Firms Insurance Firms Other Corporations Individuals 58.

8 9. This has had profound implications for corporate governance and the market for corporate control in Korea. 1997 (percent) Country Japan Korea Taipei. 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. the majority shareholder group on average held 23-30 percent of outstanding shares in the period 19881997 (Table 2. In 1997. Foreign holdings of Korean shares were 9.3 47. Institutional Investors 42. Concentration of Ownership The analysis of ownership concentration in this section focuses on shareholdings of the majority shareholder. while family members accounted for only 30 percent.18 Ownership Composition of Listed Firms in Selected Countries. the majority shareholder group in all listed companies consists of the corporate.1 percent and appear to be similar to the proportion of foreign holdings in the four other countries.3 54. including those of the largest shareholder.1 financial institutions’ establishment of corporate pension fund accounts. The majority shareholder group’s shareholdings in listed nonfinancial firms steadily declined from 1990 to 1996.4 26. defined as those holding less than 1 percent of shares. his/her family members.China United Kingdom United States Source: Stock Exchange of Korea.7 16.6 Foreigners 9.6 39. rather than the individual. and other shareholders who do not belong to either the minority shareholders or the majority shareholder group.Chapter 2: Korea 83 Table 2.3 6. only closed-end investment companies and traditional investment trust companies are allowed. minority shareholders.8 56.6 Individuals 23. and the companies under the control of the largest shareholder. Generally. for example. Among nonfinancial listed firms. investors (Table 2.5 45. But these may . corporations held 70 percent of the controlling blocks of shares.1 8. At the moment.5 20.20).8 10.19).

4 3.0 Year Corporation Individual 1992 1993 1994 1995 1996 1997 41.8 73.7 Note: The majority shareholder includes the largest shareholder.Table 2.1 28.6 2.0 4. 1992-1997 (percent) Majority Shareholders Corporation 15.0 1.8 Individual Subtotal Other Shareholders Corporation 3.3 18.3 2.6 26.9 32.9 3.1 4.1 15.9 33.1 5. Source: Stock Exchange of Korea. and the companies under the control of the largest shareholder.9 7.1 32.7 44.1 21.2 Minority Shareholders Subtotal 71.2 26.8 72.9 6.6 46. Other shareholders are those who do not belong to either the minority shareholders or the majority shareholder group.9 2.1 23.8 8.1 5.0 69.0 66. Minority shareholders are those holding less than 1 percent of shares.7 7.4 5.7 16.7 6.4 7.5 43.9 Individual 2.0 25.6 73. his/her family members.3 Subtotal 5.7 18. .1 37.2 2.0 29.0 22.6 22.2 2.0 2.6 5.19 Ownership Concentration of All Listed Firms.3 30.1 14.

6 57.7 18. Majority ownership is also high in the chemicals.0 22.5 13.8 28. the majority owner held more than 20 percent of an average firm.4 Source: Constructed from data files of the Korea Listed Companies Association. Besides. Meanwhile. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Minority Shareholders 53.9 29.3 25. and mining categories. ownership was relatively diffused due to government regulation. 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.1 50.3 62.Chapter 2: Korea 85 Table 2.9 12.21]). minority shareholders. which held less than 1 percent of a company’s outstanding shares as of 1997. 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 2.2 15.5 23.9 Other Shareholders 18. in the small firms.9 25. Ownership concentration tended to be lower in large compared to medium and small listed firms.0 58.8 54. In telecommunications.6 11. The shareholders that held more than 1 percent but did not belong to the majority group held about 20 percent on average.5 12. In most industries.9 27.8 12.8 57.22). collectively owned less than 50 percent of an average firm.0 20. . rubber and plastics. Across industry. the Government has retained a large number of shares.4 23. thereafter.5 60. The percentage of shares held by minority owners (with less than 1 percent of outstanding shares) was highest for large firms at more than 55 percent (Table 2.4 28. In such cases.8 Majority Shareholders 27. The practice of hidden shares seems to have been less prevalent in recent years.9 48.8 25. hiding shares offers no additional tax or other benefits. It was highest in medium-sized firms before 1993 and.6 58.20 Ownership Concentration of Listed Nonfinancial Firms.

Motor Vehicles Electricity.0 21.7 17.1 49.9 Minority Shareholders Majority Shareholders Other Shareholders 12.8 44.0 54.8 24.8 25. 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 36.8 21.Table 2.2 48.5 21. and Printing Pulp. and App.7 26.3 19.6 50.7 27. Paper.2 37.3 39.6 25.9 10.8 29.1 19.2 19.5 41.2 20. and Plastics Basic Metal Fabricated Metal and Machinery Electronics.21 Ownership Concentration of Listed Nonfinancial Firms by Industry.3 26.2 46.9 26.2 23.5 52. Rubber. 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.6 38.6 53.5 19.7 29.8 51. .4 11.4 Industry Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.4 16. and Printing Chemicals..5 16.8 55.2 26.5 23.0 39.9 44.5 44.7 36.5 47.1 17.7 21.1 43.0 51. Paper.2 34.7 24. Elecl Mach. Gas.4 53.8 31.2 22.0 30.6 19.5 20.8 41.6 34.

4 30.3 26.7 57.4 30.9 56.1 58.1 27.2 21.2 12.2 Majority Shareholders 26.7 16.9 12.4 47.2 55.2 11.2 52.8 27.5 12.7 14.5 19.8 56.8 62.7 15.5 26.9 55.3 25.4 29.0 24.2 32.1 20.9 23.0 66.4 30.8 52.9 22.2 Source: Korea Listed Companies Association.5 Other Shareholders 19.8 28.6 55.9 26.6 11.2 56.2 26.5 33.8 50.5 27.Table 2.7 28.0 55.3 19.9 21.7 22.6 24.2 18.1 15.0 59.5 10.2 50.7 17. of Firms 66 81 72 76 80 67 78 102 134 115 148 197 219 212 210 217 216 216 215 215 165 213 220 217 218 217 227 230 231 221 Minority Shareholders 53.6 31.0 26.9 60.1 48.6 15.5 28.6 65.9 17.6 62.2 21.22 Ownership Concentration of Listed Nonfinancial Firms by Firm Size.4 21.9 16.8 11.2 21.3 27.8 52.4 51.8 17.3 55.6 27.5 51. 1988-1997 (percent) Year Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Medium 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Large 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 No.7 31.9 53.9 28.1 16.7 57.5 19.6 59.5 12.5 21.3 21.5 49. .

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

But the controlling power of the owners also stems from inter-company shareholdings of the subsidiaries. and about 11 percent were domestic financial institutions. financial institutions that are subsidiaries of a chaebol also hold shares in its member firms. For the whole sample. Among chaebol affiliated firms. neither the investors nor the relevant government authorities were active in monitoring such unfair dealings between firms. corporations hold about 20 percent of the outstanding shares of all listed nonfinancial firms.5 corporations and two individuals.4 corporations. standalone setups. Of the 81 respondents. together having a total of 292 domestic subsidiaries. Thus. or an average of 13 firms per company.Chapter 2: Korea 89 guarantees from other members of the group at no cost. the top five shareholders consisted of 2. Until recently. Among the 81 listed firms in the ADB survey. together owning an average of 38. The fact that corporations. The extent of pyramiding can be seen in some of the previous tables. together owning an average of 37. the top 30 chaebols’ shareholding by subsidiaries was 34. 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. or about five subsidiaries each. for example. 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.5 percent.5 percent as of 1997. The top five shareholders of the chaebol-affiliated firms consisted of one individual and 3. This also partly explains why chaebols frequently opted to expand by establishing new firms rather than placing investments internally. 34 percent were foreign companies.14.23. 53 percent were domestic nonfinancial firms. In Table 2. 59 parent companies collectively had investments in 759 firms. or about four firms each. and 319 foreign subsidiaries.5 percent of shares. the average shareholding of the controlling owners and their families was 8. firms linked through partial equity investments could enjoy the advantage of consolidation without an actual formal consolidation or merger of operations taking place. not individuals. Thus. 62 percent (16 out of 26) had a corporation as the largest shareholder. For the same year. there are instances of direct cross-shareholding in Korean firms. Partial results are shown in Table 2. Twenty-two of the 81 respondents were independent. In the case of the 30 largest chaebols. 59 were parent firms with one or more subsidiaries.9 percent of shares. In many instances. Among the subsidiaries or firms receiving investments. Only six firms (or 13 percent) indicated that their subsidiaries also owned shares in themselves. although they are likely to be insignificant.

5 2.9 21.5 2.5 2.8 31.4 25.7 19.2 37.5 38.4 21.0 21.8 38.9 5.8 Note: The survey was conducted during the period January through May 1999 and included nonfinancial listed firms only.5 31.6 3.0 1.0 1.7 5.5 4.9 34. A few companies reported less than five largest shareholders.6 16.5 1.8 8.8 18.3 26.0 13.2 25.4 42.0 17.4 11.1 22. 1999 Five Largest Shareholders No. .5 24.8 37.4 18.9 29.0 3.4 2. a Number of shareholders.0 2.5 2.6 3.7 37.4 1.7 39.3 12.1 1.6 3.0 3.5 4.7 0.5 18.6 34. of Firms Largest Shareholder’s Holdings (%) Compositiona Individuals Firms Shareholdings (%) Individuals Firms Total Classification Total Sample Non-Chaebol Affiliated Largest Shareholder is Largest Shareholder is Largest Shareholder is Chaebol Affiliatedb Largest Shareholder is Largest Shareholder is Largest Shareholder is CEO an Individual a Firm CEO an Individual a Firm 81 55 31 10 14 26 3 7 16 20.1 3.Table 2.4 38. b The chaebol affiliated firms are those belonging to one of the 30 largest groups.23 Ownership Concentration in the Survey Sample of 81 Listed Firms.

Jae Woo.4 10.8 33. 1998. As of 1997.5 percent and member companies.2 1994 42.6 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. 79-95. Hattori (1989) identified three patterns based on data in the early 1980s. the controlling families owned 8. Ungki Lim. Table 2.24 Internal Shareholdings of the 30 Largest Chaebols.4 13. 6 7 Hattori. Chicago. Internal shareholdings in some chaebols also include shares owned by nonprofit organizations operated by the controlling family. 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. “Japanese Zaibatsu and Korean Chaebols.5 Judging from the historical record. Lee.2 15. 1987-1997 Type of Shareholding Internal Shareholdings Family Member Companies Source: Korea Fair Trade Commission. the ownership patterns can be described as follows.6 33. The family and member companies’ shareholdings have been declining over time.24 shows the average internal shareholdings in the 30 largest chaebols.” In Korean Managerial Dynamics. pp. Family holdings include shares owned by the family members and by parties considered to be under the influence of the family. “Is the Fair Trade Policy Fair?” Korea Economic Research Institute. Based on these studies.2 12. C.5 34.1 1997 43. 1997.4 1993 43. Tamio.4 1990 45.7 9. Many attempts have been made by researchers to identify the typical patterns of ownership structures in chaebols. . Chung and H.7 31. “The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols.Chapter 2: Korea 91 chaebol as the shareholdings of the controlling family and the member companies of the group. the average internal shareholding ratio of the top 30 chaebols was at least 43 percent. 1989. edited by K. 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.5 percent. New York: Praeger. Lee. H. 15 October 1998.” Paper presented at the Annual Conference of Financial Management Association. Table 2. 1987 56.7 1992 46.2 33.8 40. 34.0 8.

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

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

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

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

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

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

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

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

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. This action was in response to calls by international investors and. Senior managers were even often called directors although they were not official members of the board. (ii) establishment of accounting standards for financial institutions. from IMF and the World Bank. 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. However. One area has been to enhance the reliability of financial statements of corporations in line with internationally accepted standards. Transparency and Disclosure Accounting Standards The Financial Supervisory Commission (FSC) was established in April 1998 to take charge of supervising the financial markets and institutions. The commission has played an active role in introducing new rules on corporate governance. it was common for all senior executives to be elected as directors at the shareholders meeting. II Senior Executives In the past. The bonus is supposed to be linked to company performance. 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. Korean firms have rarely used shares for executive compensation. 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. executives sometimes have the opportunity to buy company shares at favorable prices because the board of directors (CEO. in particular. in practice) allocates the unsubscribed portion of new shares issued in rights offerings to executives. Vol. and . but in practice is fixed and understood as part of a fixed salary. Penalties for fraudulent financial reports were increased. but as of March 1999 only 27 firms actually had given stock options to their executives or employees. and accounting standards. 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. disclosure.

however. they also have the power and duty to monitor the activities of executive directors. The new accounting standards for financial institutions adopt the mark-to-market basis to account for securities. they cannot be expected to discharge this responsibility because the representative director selects the internal auditor and can force him or her to resign. 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. Korean listed companies with subsidiaries are required to compile consolidated balance sheets. The External Audit Act and its Decree require financial statements of corporations with total assets of W7 billion or more to be prepared and audited according to the financial accounting standards and working rules set by FSC. Only 10 percent of the respondents have followed all international accounting standards. Those that never adopted international standards show their willingness to do so once the Government introduces international standards. 41 percent of the companies believed that they have followed some international accounting standards. The new rules also require financial institutions to recognize realized losses and allowances for potential losses arising from guarantees in the current year’s financial statements. Consolidated reporting was introduced before the outbreak of the crisis. Thus. Internal and External Auditing The Commercial Code requires a corporation to have at least one internal auditor elected at the general shareholders meeting. In practice. financial institutions must report their securities holdings at market value and recognize 100 percent of unrealized holding gains or losses in the current year’s income statement. The primary sources of reference in the revision were International Accounting Standards and US Accounting Standards. but 49 percent confessed that they have not followed international standards at all. Under the Commercial Code. 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.Chapter 2: Korea 101 (iii) establishment of accounting standards for “combined” financial statements of chaebols. Most of the companies following all or some of the international standards in the past adopted such standards before the crisis started. The revised accounting standards apply to the firms subject to external auditing for the fiscal year starting on or after January 1999. In the ADB survey. the internal auditor is considered to be a subordinate of the .

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

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). Preferred shares can be nonvoting and issued up to one quarter of the total number of shares. This shows that a relatively larger number of shareholders send in their proxies. small shareholders do not attend the annual meeting and that. Internet. About one fifth of the listed firms issued nonvoting preferred shares. corporations cannot issue common shares without voting rights.” The survey shows that the Korea Securities Depository holds 69. charter amendments. The above results indicate that.21 percent of total shares issued. The management is the most important proxy.93 percent of the shareholders but 26. attended the last annual general meeting. A “special resolution” requires two thirds of the votes attending and one third of total votes outstanding.79 percent of the shareholders. The securities companies and banks are the second and third. in general. Under the Commercial Code.3. and dismissal of directors and internal auditors require a “special resolution. the Depository is instrumental in getting resolutions passed. respectively. Citizens’ coalitions sometimes solicit proxies in order to file lawsuits against a management. A total of 326 shareholders per firm. 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. 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. These voters represented only 5. the Depository is subject to “shadow voting. However.53 percent of the total shareholdings. for some firms.77 percent of the shares.” Companies can increase the number .” meaning that it should divide its votes in accordance with the accept/reject ratio of votes cast by other shareholders attending the shareholders meeting. representing 62. However. Thus. No companies have so far introduced voting by mail. amendments of the articles of incorporation require a “special resolution. Approval of mergers and major divestitures.3 Shareholder Rights Voting Rights and Practices Under the Commercial Code. One common share should have one vote. or 10. or telephone. the only purpose of allowing the Depository to vote was to help listed companies to meet the quorum requirement for the general shareholders meeting.Chapter 2: Korea 103 2.

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

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

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

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

Vol. will get involved in the restructuring and workout processes. The leading creditor banks will continuously monitor the progress in implementing the signed Plans. 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 1998.5 The Market for Corporate Control Government Policy Toward Hostile Takeovers Until 1994. 2 percent by holding companies.108 Corporate Governance and Finance in East Asia. Under a contract signed between the creditors and the debtor. and 1 percent by the Government.3. This agreement will provide guiding principles in coordinating diverse interests among creditor institutions and promoting cooperation. a Lead Creditor Council Agreement was signed for restructuring the top five chaebols. are summarized below. have been the driving forces for restructuring activities of the largest 64 chaebols. In cases where the creditors are unable to reach an agreement on a workout plan. the delegation has the right to approve wide-ranging financial activities of the firm. the Korean Government maintained a policy of protecting the incumbent management of listed companies. especially banks. major creditors. the lead creditor banks formally signed Capital Structure Improvement Plans with chaebols. First. 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. banks and other institutional lenders are playing more important roles than ever before. The new ways through which creditors. This committee was set up in accordance with the provisions of the CRA. Behind these new strengthened roles of creditors is the newly set-up FSC. the Corporate Restructuring Coordination Committee (CRCC) will provide arbitration. II by other affiliated companies. Third. including commercial and merchant banks. the creditor banks will send a delegation composed of bank officers to the workout firm to oversee its management. In this connection. 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 . 4 percent by subsidiaries. Second. 2. and in continued monitoring of debtors. Separate from but emulating the CRA.

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

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

The Government has frequently imposed restrictions on the use of capital markets by large companies. administering through a self-regulatory committee of the securities industry.3. There is no active debate or discussion going on about this potentially difficult issue. Labor is not represented in corporate boards. This was aimed at limiting the supply of bonds thereby stabilizing interest rates. For example. each of the 10 largest chaebols was allowed to raise funds no more than 4 percent of the total market capitalization of the member firms. The objective of the system was to improve the financial condition of the chaebols and to promote the soundness of bank management. which limits the total amount of bonds issued by the five largest chaebols. In addition. the main bank system. It was abolished before the economic crisis but another regulation. which was introduced in 1996. There were also limits on the amount raised and the number of issues per year. But this rule. especially those belonging to chaebols. and approved by the Chairperson of the Planning and Budget Commission. 2. Further. was amended in 1997 to introduce a board structure consisting of a majority of nonexecutive directors. Beginning in 1999.1).7 Employee Participation in Corporate Governance Employee participation in corporate governance is very limited. The nonexecutive directors are now recommended by a committee.Chapter 2: Korea 111 The Government used to appoint a few public officials to the boards of state-owned corporations. Meanwhile. only qualified firms could issue new shares. as applied to four large corporations. is being applied to the 51 largest business groups to which the banks extended more than W250 billion in loans and payment guarantees. nominated by the minister in charge of the company in question. The Government’s right to send public officials to the boards was eliminated. 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 Government.3. went into effect in 1998 to prevent them from absorbing too much of the funds available in the market. more state-owned corporations became subject to this new board structure. Even where employees hold . controlled the total amount of corporate bonds issued per month and allocated amounts to individual corporations.

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

Chapter 2: Korea 113

2.4 2.4.1

Corporate Financing7 Overview of the Financial System

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

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

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

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

Chapter 2: Korea 115

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

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

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

Chapter 2: Korea 117

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

the Korean Government announced its Financial Liberalization and Market Opening Plan. which resulted in the establishment of a number of new banks. the Government simplified various directives and instructions regulating personnel management.2 Patterns of Corporate Financing Corporate Financing Practices In this section.5 percent in November 1981. mutual savings. finance companies. the business scope of financial institutions was greatly widened from the early 1980s. II Interest Rate Deregulation Plan. the required reserve ratio was substantially lowered from an average of 23 percent in 1979 to 3. Also. Internal funds include retained earnings. and organization of commercial banks. entry barriers to banks and NBFIs were lowered in an attempt to promote competition. The Government handed over its controlling stakes in four commercial banks to private hands in 1981-1983. flow of funds analysis was used to examine patterns of financing of the aggregate corporate sector. etc. . The capital market. Some policy loans were also abolished. The plan was launched partially to accommodate US demands for comprehensive structural deregulation and market opening of the financial sector. The Government adopted a cautious approach. development of the money market. budget. especially the domestic bond market. It included such important issues as interest rate deregulation. the following measures can be constructed: Self-financing ratio (SFR) is the ratio of change in internal funds to change in total assets. Korean firms have been allowed to issue CBs in international financial markets. listed companies. Meanwhile. opting to bring in the plan step-by-step to avoid market dislocation from a sudden shift in the system. Since 1985.118 Corporate Governance and Finance in East Asia. depreciation. short-term finance companies.1). and the 30 largest chaebols. On the basis of flows of funds. In June 1993. as a first step toward liberalization of capital account transactions. With the privatization of nationwide commercial banks. and liberalization of foreign and capital transactions. In addition. Vol. The Government began to considerably deregulate foreign exchange in 1987 due to the shift of the current account into surplus in 1986 (see 2. Moreover.4. implementing the first stage in November 1991.2. revision of the credit control system. the Government announced a plan in 1981 that substantially improved foreign investors’ access to the domestic capital market. 2. was liberalized drastically in 1998 after the financial crisis.

was 71 percent during the period. capital surplus. The corporate sector used . This high proportion deprived Korean businesses of flexibility during recession periods due to high financial costs. The share of external financing.25 shows the flow of funds of the nonfinancial corporate sector in Korea during 1988-1997. particularly in the 1990s in response to the liberalization of the capital market. but it remained less than 10 percent of total financing. In securities finance. Securities finance became a more important source from 1988 onwards. except for the stock market boom of 19871988. In 1988 when the stock market boomed. and 1997.25. and allowances) and new equity capital. depreciation.26 shows the four measures of corporate financing calculated from Table 2.Chapter 2: Korea 119 and net capital transfers from the Government. except in 1991. depreciation. New equity financing ratio (NEFR) is the ratio of change in equity (stocks issued + equity other than stocks) to change in total assets. Incremental debt financing ratio (IDFR) is the ratio of change in total borrowings to change in total assets. Meanwhile. including all sources other than retained earnings. the proportion of foreign borrowings in total finance rose steadily. but do not include capital surplus (asset revaluation allowance and the excess of current value over issue value of stock). Financing Patterns of the Aggregate Corporate Sector Table 2. Before 1988. The SFR averaged 28. Equity capital represents the shareholders’ commitment to the business.4 percent in the precrisis period 1988-1997. It measures the degree of financing growth in total assets by additional equity. financing by corporate bonds and CPs was more significant than by new equity. The use of additional debt to finance growth increases financial risks as the company may not be able to pay interest during periods of recession or high interest rates. Table 2. particularly in the short term. on average. Additional equity capital used to finance growth reduces the financial cost and the financial risk of investment. comprising internally generated capital (retained earnings. This means that internal funds after dividend payment were insufficient to finance growth in total assets. It measures the degree of financing growth in total assets by additional debts. Incremental equity financing ratio (IEFR) is the ratio of change in stockholders’ equity to change in total assets or 1-IDFR. the proportion of borrowings from NBFIs fell to its lowest value at 4 percent. 1994. and government transfers. the corporate sector’s most important source of external finance was bank borrowings.

and Flow of Funds.2 5.7 1989 1990 1991 1992 1993 1994 1995 1996 22.4 27.5 2.4 1.0 3.4 2.6 1.5 16.1 (0. b Includes capital surplus.4 27.9 72.1 2.7 — — — — 9.6 5.8 1.7 73.7 1.0 11.5 13.0 2.9 0.4 8.5 2.4 — 28.7 10.4 11.2 2.3 2.6 3.6 25.8 1.1 1.1 72.1 27.0 9. 1994.9 10.2 10.7 7.4 21.6 11.7 1.5 16.7) 11.8 — 26.5 0.7 2.4 71.4 27.6 9.0 70.7 10.1 — — — — 12.9 6.3 27.0 — — — — 8.9 10.5 2.4 (0.4) 13.1 8.4 2.8 17.0 (0.1 36.8 (0.4 (2.3 1.7 8.6 0.8 4.7 14.7 10.1 1.6 4.3 3.8 8. Bank of Korea.3 — — — — 8.9 73.0 5.1 2.7 12.1 3.2 (0.Table 2.3 10. 1988-1997 (percent) 1988 43.1 12.9 34.7 71.3 — 30.4 0.1 10.3 6.6 8.7 13.7 8.2 13.2 6.8 1.2 6. which is the excess of current value over issue value of stock.8 56.4 1. depreciation.0 10.4 3.0 1.8 15.8 0.1) 6.6 (0.0 22.2 0.6 10.9 2.4 0.5 0.4 2.0 0.7 14.1 0.3 16.0 3.6) 5.6 4.6 2.2 26.5 9.6 0.4 15.4 2.1 3.9 38.7 15.0 0. a Includes retained earnings.7 2.2 15.2 1. Bank of Korea.1 1.3 1.4 10.8 -2.6 0.0 16.1) 4.1 (1. 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.3 1.1) 4.2 — — — — 9.7 2.3 5.3 72.0 1997 26.2 14.7 4.4 9.1 0.3 25.8 1.8 1.0 17.7 4.6 9.8 27.1 3.6 Sources of Funds Internal Financinga External Financing Bank Borrowings Banks Nonbanks Merchant Banks Insurance and Others Securities Natl.3 6.7 11.1 — 27.7 32.1 23.0) 12.5 0.6 11.2 34.3 3.3) 15.5 2.2 — 28. .25 Flow of Funds of the Nonfinancial Corporate Sector.6 3.0 3.6 0.3 6.3) 11. Source: Understanding Flow of Fund Accounts. and net capital transfers from the Government.9 9.8 30.6 14.3 30.6 77.7 6.7 (0.6 4.5 29.6 9.9 28.0 9.2 13.1 17.

dropping to 26.2 percent of the growth in total assets. .0 42.1 percent in 1988 during the stock market boom. Across industry.3 11. additional equity to finance 12.6 percent.Chapter 2: Korea 121 Table 2.3 12.4 12.7 26.7 40.5 31.6 percent.5 percent in 1997. On average.3 59. IDFR reached 73.4 percent. Manufacturing financed 54. NEFRs. Bank of Korea.0 11. higher than the aggregate 28.27).1 17. Incremental financing from equity was 40. In periods of high economic growth such as in 1988. While SFRs.9 28.7 30.9 46.8 28.7 40.6 percent and 1. in the manufacturing sector. 1994.4 IEFR 63.3 60.8 62.5 68.0 57. respectively.5 and 76. There were significant time trends. declining to 26. the corporate sector relied heavily on external financing for its expansion.8 10. and Flow of Funds.9 22. an average of 59.6 26.3 73.4 37. and IEFRs were declining. SFR peaked at 44 percent. Bank of Korea.3 percent in 1997.7 40.1 53. but also continuously fell. was financed by additional debts. Source: Calculations from Understanding Flow of Fund Accounts.6 62.0 5. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average a SFRa 43.9 percent by 1997 when net profit margins were negative. Lower income diminished the industry’s equity position toward crisis year 1997.5 12. IEFR ranged from 32 percent to 64 percent of asset growth during the boom years. indicating a high financial risk position.1 12.4 percent (Table 2.3 59. average SFR was 37.1 26.7 percent in 1997. respectively. It dropped to 28 percent the following year.26 Financing Patterns of the Nonfinancial Corporate Sector. 45. and the total debt ratio was much higher in 1996 and 1997 at 62.3 27. higher than the aggregate 40.2 37. but plunged to 5.6 percent over the 10-year period.2 IDFR 36.6 Excludes capital surplus. Its IEFR and NEFR dropped to 23.2 percent of incremental asset growth was financed by equity.7 28.7 9.9 60.5 percent.4 27.1 39.4 percent.8 percent of its total asset growth through debts. NEFR registered 20.0 27. The balance.4 NEFRa 20.

then increased to 20.5 1. and communication sector had relatively high incremental equity ratios. which decreased to 8.7 37. Since large firms were more profitable. II The construction industry showed the most cyclical pattern in annual asset growth. These sectors had relatively low equity financing ratios and high total debt ratios in financing asset growth between 1988 and 1997.2 5.4 37.8 IEFR 65. Categorized according to company size. On the other hand. Equity financed an average 25. the utilities (electricity.6 53.2 21. gas.5 76. In 1997. Financing patterns of the wholesale.0 57.8 4.5 NEFRa 9.6 53.4 3. with the total debt ratio much higher in 1995-1997 at 82 to 84 percent. the proportion of short-term borrowings in total financing has been high. and hotels sector and realty/renting/business activities sector were similar. It had the highest average SFR in 1988 at 31. and steam) and the transportation. and fell to about 10 percent in 1997.7 37.5 7. explaining partly the collapses of several construction companies in 1995. from 17.6 37. and low total debt and short-term borrowing ratios.2 62. Total debt financed an average 74. one year ahead of the other industries.6 54.6 3. the two sectors also had low equity financing ratios and high debt financing ratios.3 28.2 .9 IDFR 34.4 45.7 47. storage.7 47.4 47.6 37.0 30. Since 1992.9 6.and medium-sized firms.7 percent in 1996.6 62.6 4. large firms showed more cyclical patterns in these financing ratios than small. retail.8 percent in crisis year 1997.0 42.8 50. Vol.3 52.9 percent.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 50.0 42.5 23.4 46.2 percent in 1993. Table 2. this dropped further to 15.6 45.4 54.1 percent of total asset growth for the period. their average SFR was higher.2 3.9 percent of asset growth.1 29.0 3.4 63.8 percent in 1990.6 36.122 Corporate Governance and Finance in East Asia.

5 1993 22.1 4.5 23.3 4.27 (Cont’d) Year SFRa NEFRa IDFR 53.6 4.2 18.7 15.6 8.5 1996 42.8 4.2 3.0 34.6 9.9 1.9 Average 19.5 62.6 9.6 71.0 17.2 70.1 70. and Communication 1988 64.6 8.1 1991 14.0 .2 10.4 26.Table 2.1 69.2 20.7 1997 8.6 37.5 1.4 1995 53. Storage.9 1992 56.7 41.9 9.4) 2.1 59.9 29.0 74.0 1990 12.0 65.8 76.0 82.3 47.1 66.8 29.9 1993 63.9 33.7 1994 53.0 60.1 25.3 84.1 19.7 1989 26. Household Goods.7 15.3 21.3 8.9 20.0 3.8 25.4 62.7 78.3 7.4 IEFR 46.9 80.7 6.8 2.4 28.3 1996 16.4 2.3 19.7 7.8 9.0 1990 50.2 8.7 Wholesale/Retail Trade.8 1994 15.2 4.6 73.9 1989 63.2 1995 16.2 74.3 (9.3 57.5 76.8 70.9 30.2 29.0 31.5 70.0 1992 24.9 1.9 52.8 74.0 1.1 84. Hotels 1988 33.3 10.2 23.5 29.7 78.7 42.0 10.5 12.6 7.2 Average 53.6 37.0 0.6 2.8 54.9 2.5 20.3 4.2 5.7 80.9 16.8 1991 51.1 Trasport.9 15.2 25.6 1997 29.9 47.6 14.5 87.0 40.0 68.5 21.0 4.8 81.7 53.2 46.9 1.9 Construction 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 31.

0 43.124 Corporate Governance and Finance in East Asia.0 21.3 29.4 47.0 1997 24.4 1.7 70.6 1997 23.1 35.1 42.4 5.7 14.1 54.9 45.5 77. SFR = self-financing ratio. The trend was reversed in 1996-1997. IEFR = incremental equity financing ratio.9 57. when large firms had much lower equity financing ratios and higher debt financing ratios than small.4 0 0 0 0 1.0 79.6 1989 118.9 29.6 7. Source: Calculated using data from Bank of Korea. and Steam Supply 1988 118.and short-term borrowings of these firms shot up in that period.0 0.7 1994 8. and Business 1988 51.2 63.0 53.5 8.1 34. Gas.8 1990 19.4) 3.and mediumscale firms.2 1992 18.9 IDFR 31.0 67.5 22.9 28. Vol.1 0.1 1989 34.4 7.8 17.3 81. The large firms had a higher proportion of external financing in 1996-1997.7 18.4 1996 45.27 (Cont’d) Year SFRa NEFRa 6.6 1995 17.8 1993 11. Their average IEFR was also higher and IDFR smaller. Financial Statement Analysis Yearbooks.1 1991 56.6 Real Estate.4 1995 62.4 0. Higher growth in total assets and sales and easier access to debts by large firms could be reasons for this.3 85.9 65.9 64.6 52.0 33.3 7. a Excludes capital surplus.1 70.8 Average 22. NEFR = new equity financing ratio.0 0.1 71.3 Electricity.8 36.3 207.3 3. Long.7 69. .3 92.7 1996 18. however.0 1.3 62.7 37.6 IDFR = incremental debt financing ratio. II Table 2.8 135.0 46.6 1.0 56.0 (0.4 (107.4 1994 72.0 1992 51.3 31.6 1990 82.9 Average 75.8) (35. Renting.4 IEFR 69.8) 7.1 1993 55.6 1991 18.

the average SFR was 28. All of the top 30 chaebols relied heavily on short-term borrowings.30).3 and 89.7 percent. compared with the entire corporate sector’s 35 percent and 65. at an average 70.2 percent. about the same as that of the corporate sector as a whole.1 percent of their equity capital.4 percent. Their shortterm borrowings accounted for 86. The proportion of their short-term financing averaged 72. In 1997.8 percent. Financing Patterns of Chaebols For chaebols. In 1996-1997. and were large borrowers. 153.5 percent and their total external financing. and the top five chaebols.9 percent. Group-member firms borrowed less. and using cross-payment guarantees among affiliated companies.3 percent of their equity capital in 1997 (Table 2. The debt financing ratio of listed companies was high since they relied more on external financing. 91. respectively. The largest borrowers were the top 11-30 chaebols. Many firms affiliated with the top 30 chaebols saw loan guarantees turn into their own debts because of defaults in debt payments. . the IDFR of listed companies increased to 93. External financing reached 94. The average IEFR of the top 30 chaebols of 29.29).9 percent. the top 11-30 chaebols had the highest guarantees commitments at 207. for listed companies. The chaebols’ drive to expand their empires resulted in heavy borrowings.7 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.6 percent. Cross-payment guarantees have been declining since 1993 and reached 91. Another key feature of corporate finance in Korea is the widespread use of loan guarantees among the top 30 chaebols.6 percent of total asset growth. The average IEFR and IDFR were 10.28). They were able to borrow easily from banks by issuing corporate bonds and CP.Chapter 2: Korea 125 Financing Patterns of the Publicly Listed Firms The average SFR of listed companies in 1994-1997 was much lower than that of the corporate sector as a whole (Table 2. the lowest ratio of 58. and higher than that of listed companies (Table 2.8 percent of their total finance in 1997. In 1997.5 percent is lower than that of the corporate sector in general. the NEFR of the top 30 chaebols plunged while the debt ratio increased substantially.7 percent for all listed companies. compared with 89. the top 6-10 chaebols.

6 0.3 5.4 38.6 61.7 13.5 8.3 Year 1994 1995 1996 1997 Average a Excludes capital surplus.6 70.8 22.4 12. 1994-1998 (percent) SFRa IDFR 85.9 6.29 Financing Patterns of the Top 30 Chaebols.4 88.8 76.2 23.6 1.5 2.5 2.6 11.3 86.7 12.4 1.3 28.1 93.1 1. Source: Calculated from data obtained from data files of the Korea Listed Companies Association.4 29.2 36.5 91.2 10.3 1.5 Year 1994 1995 1996 1997 Average a Excludes capital surplus.9 7.2 1. Largest Business Groups in Korea.28 Financing Patterns of Listed Companies.8 89. Korea Federation of Industries.1 8. Source: Calculated using data of Seung No Choi.Table 2. .5 8.2 NEFRa 1.3 IDFR 57. Table 2.6 IEFR 42. 1994-1997 (percent) SFRa 41.9 NEFRa IEFR 14.7 1.

3 58. Korean firms preferred debt financing (bank and nonbank borrowings). Factors Influencing Corporate Financing Choices Until recently. Second.9 — — — 1994 258. the Government applied high tax rates on net profits of corporations. so that the firms engaged in lobbying to gain access to them. poor financial and corporate governance resulted in overlending by banks.3 64. and extended loans based on cross-payment guarantees. Further. and reserves and retained earnings. Few firms ranked loans from NBFIs as their first preference. This change implies that firms now give more attention to financial risks. This attitude appears to have changed after the crisis because reserves and retained earnings and rights issues became the preferred financing choices. Controlling shareholders usually tried to avoid dilution in their shareholdings for fear of losing control. First.1 — = not available. Fourth. inefficient investment and excessive diversification of corporations. and loans from NBFIs. According to the ADB survey.9 — — — 1996 105. There were several reasons for this. 1993-1997 (as percentage of equity capital) Rank Top Top Top Top 30 Chaebols 5 Chaebols 6-10 Chaebols 11-30 Chaebols 1993 469. especially in the 1970s when real interest rates of bank loans were negative. Source: Fair Trade Commission and the Federation of Korean Industries. the Government provided implicit guarantees on bank lending and large businesses. bond issues. Firms now prefer internal funds and new equity capital. chaebols could easily borrow funds from banks and NBFIs by using cross-payment guarantees. . And fifth. loans from banks. the Korean economy was plagued with high inflation.0 207. and underdevelopment of the stock market. Interest payments on debts were considered a loss when calculating taxes. in order of ranking. Financial institutions did not strictly screen their loan projects and monitor their debtors. These are followed by loans from banks.1 — — — 1995 161. company preferences in financing investment projects before the crisis were.Chapter 2: Korea 127 Table 2.7 150. Third. rights issues.0 1997 91. more than half of bank loans were priority loans with low interest rates.30 Cross-Payment Guarantees of the Top 30 Chaebols. bond issues.9 153.3 200.

A futures exchange launched in 1999 trades foreign exchange options.3 Financial Structure. in selecting financing sources. and others (29 percent) expected the local currency to appreciate in value. Among the responding companies that had foreign currency denominated loans. Diversification.4. the majority (60 percent) of the firms responding to the ADB survey look first for nonaffiliated financial institutions. Vol. These survey results indicate that many companies were not very attentive to exchange rate risks (and possibly to financial risks in general). and futures and other financial derivatives. The percentage of foreign currency denominated loans hedged against exchange rate risks was 21. Among those that never hedged against exchange rate risks. About half of the respondents of the ADB survey borrowed foreign currency denominated loans from foreign banks. According to the survey. even with a heavy debt burden. 2.36 percent on average for these companies. 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. Korea now provides a better environment for financial risk management. ensuring the liquidity of the company. Only a few firms sought foreign loans because domestic loans were not available. Few companies felt that hedging was too costly or was unnecessary as the exchange rate was considered fixed.128 Corporate Governance and Finance in East Asia. 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. For these firms. they survived for two to three . some (36 percent) thought that a hedging facility was not available or not working properly. the percentage of foreign currency denominated debt in the portfolio was 14. Other factors include. II In seeking external financing. more than half (53 percent) hedged against exchange rate fluctuations. This preference has changed little after the crisis. and reduction in tax burden. maintenance of the existing ownership structure. in order of importance. firms give their first consideration to minimization of transaction and interest costs. many firms (or 42 percent) never considered hedging.5 percent at the end of 1997. Nonetheless.

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

the degree of diversification was highest in the top five chaebols. In terms of the net profit margin (the ratio of net profits to sales revenue). Government intervention. 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. This indicates that excessive diversification and inefficient investment of the top 30 chaebols resulted in relatively low net profit margins (Table 2. however. The differences in the degrees of diversification among the three groups are substantial. had easier access to credit than the top 31-72 chaebols. Vol. Indicators such as increasing debt-to-equity ratios. the top 6-30 and 31-72 chaebols gradually increased their diversification beginning 1990. had a significant role.5 The Corporate Sector in the Financial Crisis This section looks at the various causes of the crisis in 1997. and lowest in the top 3172 chaebols. too. debt guarantees for free. 2.130 Corporate Governance and Finance in East Asia. The diversification of the top five chaebols remained at about the same level within the period. its profit rate declined. larger research and development expenditure. The diversification of chaebols under workout was much lower than that of the top 6-30. and easier access to cheap credit. or outright transfer of resources due to poor corporate governance practices. Chaebols have been subsidizing new or low-profit industries by transferring resources from high-profit industries through inside dealings. The degree of diversification of chaebols that fell into default. rising nonperforming loans (NPLs) and falling . II Corporate Performance and Diversification As a chaebol further diversified into nonrelated areas. Factors related to weak corporate governance were closely intertwined with shortcomings in macroeconomic policy and vulnerabilities in the financial sector. Their subsidiaries. the top five chaebols outperformed the top 6-30 chaebols for most of 1985-1997.31). net profit margins of the top 31-72 chaebols were always higher than those of the top 6-30. second highest in the top 6-30. Meanwhile. then declined to levels lower than those of the top five in the years of economic downturn 1993-1997. and composition was lower than that of the top 6-30 but higher than that of the top 31-72 chaebols on average. except in the recession years of 1996-1997. court receivership. During 1985-1997. But the net profit margins of the top 31-72 chaebols were higher than those of the top five in 1985-1992.

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 1.3 3.6) (0.0 (2.1 0.8 3.0) 0.7 0.3 1.6) (12.0 1.2) 0.6 0.1) 0.6 1989 1.5) (7.7 1.1 0.2) (4.7) 0.3 1.4 (1.1 (1.8) 0.3 0.4 1996 0.6 0.6) 0.1 (0.8 1990 0.6) (12.8 0.6 (0.4 0.9 0.5) (2.5 1.0 1992 1994 1.6 0.8 (0.6 0.1) (1.8) (37.3 1.6) (0.8) (20.9 0.8) 0.7) (1.8) 0.6) 0.11.1) — = not available.7 2.2 1.3 0.1 4.5 (0.3) 0.8 (0.3 1.2 (0.9 1.2) (3.7 1.4 (2.8) (1.4 (1. .3) 12.4 (0.5 (0.6 1. Court Receivership.6 3.9) 2.3 (0.3 (3.7 0.3) 1.1 1. Background and Task of Structural Adjustment.0 4.2) (13.0) 0.4 2.7 (4.1 2.5 2.6 0.9 1.1) (2. 1985-1997 Item Top 5 Hyundai Samsung LG Daewoo SK Top 6-30 Top 31-72 Default.3) (12.7 0.3) 1.0 0.6) 0.8) 2.9) 2.5 0.1 (4.1 0.3 0. 1998.5 (0.8) 1997 0.2) 2.4) (1.1) 0.8 0.2) (13.9) (9.1 (3.31 Net Profit Margins of Chaebols.6 7.4 0. Chung Ang University.2) (0.3) (1.7) (0.7) (0.6 (10.5 1.6 (0.3 1.2) 1.6 1.1 1.4) (4.0 1.3) 0.2 (0.4 (1.3 1.8) 0.2) 1.8 3.2 (0.4) (1.1 0.2 0.7 (1.2 1995 3.9 8.4) (2.3) (0.7) 0.9 1.0) (4.2) 2.8) (3.9) (8.5 4.2 4.4 1.1) 2.2 (0.0) 0.2) (0.8) (11.5 (4.1 0.7 — (0.5 1.8 0.8 0.0) (0.5 1.8 0.4) (6.0) (3.3 (0.4 1.0 1987 1.3) 0.4 (0. p.7 0.6 0.1 1.5) (1.2) (4.9) (1.0 (0.1) (6.3 1.6 5.7 0.3) 0.0) (0.5 (0.1) 2.2 1.3 (0.1 0.9 0.4 1.6) 0.4) (1.3 0.9 (0.8) 1.1) 1.2) (4.5 (6.1 1.9 0.6 1.5 1.4 1.7 0.4 (0.3) (0.5) (2.1 (4.7 1.3) 0.2 1.1 1.7 1.3 1.7 (0.8 1.1 0.2 (17.2 1.1 1.3 1.5) 0.1 0.3 1.0 (7.1 0.0 6.7 (0. Management Research Institute.8) (1.2) 1.8) (0.8) (4.1) (5.5) (0.1) 1.2 1.Table 2.8 1.6 0.6 1.2 1.0 0.3 1.2 (1.3) 0.9) 0. Source: Whan Whang.6 1.3) 0.3 0.8) 0.4 0.9) 2.8 (0.4 0.1 (9.6) (20.1) (1.6 0.3 (0.9 1.1 1. Beyond the Limit.7 3.4) (0.

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

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

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

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

Following the “three months” definition. The Government could hardly help them because of the number and magnitude of business failures. were low in 1996 and 1997. a large number of construction companies failed due to the recession in the real estate market and decline in real estate prices. Meanwhile. has given rise to various types of self-dealings by the controlling shareholder. legal and other barriers prevented the exit of financially nonviable firms. These were the definitions until 30 June 1998. Doubtful loans are those for which interest is not received for six months or longer. The banks and merchant banks lent to large businesses.000 from December 1997 to February 1998.6 percent in June 1998.000 per year starting 1992. regardless of whether it is caused by large personal holdings of the controlling shareholder or by pyramiding. . and there is no collateral.7 percent in 1997. excluding the financial sector. they are defined as loans for which interest payments are overdue by three months or more. total assets. nine out of the 30 top chaebols failed. reaching highs of 6 percent in 1997 and 8. Fixed loans are those for which interest is not received for six months or longer. the ratios of net profits to sales. and estimated losses. They utilized mutual payment guarantees among their affiliates and believed that they would never fail. especially chaebols. The inevitable result of inefficient investment was a fall in corporate profits. Financial Sector Vulnerability Because of financial losses in the corporate sector. and shareholders’ equity of all industries. In 1997 they became negative. II Inefficient Corporate Investment and Low Profitability Ownership concentration among Korean firms. Before the crisis. Further. then 20. Overlending and inefficient investment were also a result of moral hazard due to implicit government guarantees and “too big to fail” legacies to large businesses. the NPL ratio8 of banks and other financial institutions began to increase. The number of insolvent companies increased rapidly in 1991 and doubled to more than 11. decelerated from March 1998.32). The bank supervisory 8 NPLs of banks comprise fixed (substandard) and doubtful loans.200 in 1997. and returned to about 1.136 Corporate Governance and Finance in East Asia. However. without strictly evaluating the creditworthiness of businesses and the profitability of projects. Vol. and there is collateral.000 in September 1998 (Table 2. According to the “six months” definition. The monthly number reached more than 3. starting 1 July 1998.000 during January-September of 1998. It jumped to 17. and the pursuit of growth through excessive diversification and inefficient investment.1 percent in 1996. the NPL ratio reached 7. Moreover. the NPL ratio of commercial banks increased rapidly from 4.

114 811 706 696 866 1.673 Construction 380 354 242 195 294 585 1.250 2.985 Services 3.502 11.517 2. The current account deficits in terms .751 1.544 2. those of domestic banks were lower in the 1990s.992 11. Meanwhile.107 6.China. 1986-1998 Year 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total 4.238 4.053 5. 2. low efficiency.589 171.027 Manufacturing 1.754 3.637 6.259 2. Compared to ROAs and ROEs of domestic branches of foreign banks.133 3. and declined to 4-6 percent in 1994-1996 (Table 2.769 9. authorities were not too concerned about the high NPL ratios at Korean banks in 1997 simply because the high and rising ratios had precedents.850 3.255 13.131 1.573 3. 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.472 2.159 10.553 3. Policymakers thought that economic growth would resolve the NPL problem without the need for corrective action.210 1. Exchange rates were virtually pegged to the US dollar in all troubled Asian countries. As a result they had largely overvalued currencies.855 6.Chapter 2: Korea 137 Table 2. Source: Bank of Korea.856 7. ROEs and ROAs of Korean and Japanese banks were low compared with those of the US.979 8.4 Shortcomings in Macroeconomic Policy The macroeconomic framework also contributed to the crisis in 1997.244 3.135 1.386 5.417 Others 152 132 108 97 88 161 326 252 274 302 553 861 952 Note: 1998 figures cover only January-September.890 4.657 3.457 2.265 6. and continuous and large current account deficits.69 20.32 Number of Firms with Dishonored Checks. This was mainly due to the high ratios of NPLs. the ratio reached 7-8 percent.859 3.33).5. European countries.647 8. This speculation was said to be one of the causes of the financial crisis in Korea.759 6. and Taipei. In 1990-1993. and large government-directed loans.

116 1.2 4. the ratio of short-term debt to foreign reserves was very high.739 241. Meanwhile large businesses could not legally lay off workers.0 8. In 1997. In addition to the overvaluation of the won.0 7.1 6. The pegged currency also encouraged foreign borrowing as investors believed that the exchange rate would remain stable. although per capita income in Korea was much lower.827 289.077 NPL Ratio (%) 8.4 5.China.6 percent (1995).832 337.0 7.584 2. which led to large corporate losses. It was estimated that the Korean won was overvalued by 20 to 30 percent from 1989 to 1997. Thailand -8. Real interest rates in Korea had been two to three times higher than those of Japan or Taipei.310 6. the terms of trade deteriorated 12 percent in 1996 and 11 percent in 1997.8 5. Mass layoffs became legally possible only after the economic crisis. .910 1. and Indonesia -3. 1990-1998 (W billion) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 a Total Loans 90.1 7. Vol. because of the rigid labor market.1 percent (1995). Businesses served as a social safety net.221 8. the hourly wage rate in the Korean manufacturing sector was higher than in Singapore or Taipei.600 10.China.736 8. of percentage of GDP were as follows: Malaysia -8.390 12.652 29.176 7.639 1.237 Estimated Loss (C) 958 920 840 816 213 385 490 490 648 NPL (A+B+C) 7. Related to this.556 118.537 10.997 9.562 18.160 11. b Doubtful loans are collateral-free loans for which interest is not received for six months or longer.584 Fixed (A)a 5.266 10.170 1.475 143. Source: Bank of Korea.8 percent (1996).138 Corporate Governance and Finance in East Asia. judging from the real effective exchange rate indexes using unit labor cost indexes as a deflator and 1985 as a base year. Land prices and real estate rents were also high compared to trading partners.6 percent (1995).192 Doubtful (B)b 952 1. The main result of the rigid labor market was a “high-cost and lowefficiency” economy.190 9. II Table 2.484 11. Korea -4.6 Fixed loans are those requiring collateral and for which interest is not received for six months or longer.33 Nonperforming Loans of General Banks. even in times of economic slowdown.649 375.954 9.520 194. and 30 percent in 1996.874 22.430 12.705 160.929 11.

including banks. The FSC—later called the Financial Supervisory Service (FSS)— which is in charge of prudential regulation of financial institutions. However. A guideline informally promulgated by FSC required the 30 largest chaebols to lower their DER of 412. and subsidizing money-losing units. . ‘Voluntary’ Restructuring Chaebols have been under pressure from the Government to abolish their informal group headquarters to increase the managerial independence of member firms. 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. Ailing banks needed to be recapitalized after the huge amount of NPLs was disposed. To achieve this. the excessive amount of debt of Korean corporations had to be reduced to a sustainable level. 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. which were laden with huge amounts of debt and were on the verge of bankruptcy. the immediate objective centered on restoring the international investment community’s confidence in the Korean economy.6. Nonviable firms and financial institutions. embarked on their own restructuring programs and/or implemented restructuring demands of the creditor banks. Corporations. Other firms experiencing financial distress were subjected to workout procedures through negotiations between debtors and creditor 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. has been actively utilizing its influence to motivate institutions to coordinate debtor firms’ restructuring activities.Chapter 2: Korea 139 2. had been forced into bankruptcy proceedings or merged into healthier entities.6 2.1 Responses to the Crisis and Policy Recommendations Corporate Restructuring Activities Restructuring activities in the corporate and financial sectors of the Korean economy were aimed at enhancing their long-term viability and competitiveness. They have been pressured to stop such practices as providing loan guarantees.6 percent as of the end of June 1998 to no more than 200 percent by the end of 1999.

The data also show that about 24 percent of acquisition negotiations ended up in actual deals. Korean firms have been slowly stepping up their restructuring since the latter half of 1998 as the economy began to show signs of recovery. In their first review. More important.045 in October. More than 59 percent of potential buyers were foreign firms. 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 1998.138 by the end of October. The reasons are manifold. On the other hand. 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. Internationally. Locally. II Divestitures to raise cash for debt reduction and to focus on core businesses have not proved to be easy. banks and other creditors were reluctant to absorb losses realized by debt compositions. 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. or to agree on debt-equity swaps demanded by potential purchasers as a precondition for the deal. Banks did not have the incentive to force financially nonviable firms to liquidate. It was frequently observed that the negotiating parties could not agree on a price due to large discrepancies in valuation. FSC directed banks to appraise the long-term viability of client firms showing symptoms of failure. Involuntary Exits The Government has been involved in the restructuring process mainly through its supervisory capacity over banks. This number was at 779 firms in April and grew to 1. potential foreign buyers waited for the price of acquisition targets to come down further. the creditor . because liquidation of debtor firms would exacerbate the banks’ already weak balance sheets. Noticing this disincentive.281 in April to 2. 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. they were reluctant to allow recontracting for fear of further deterioration in the capital adequacy ratio. the number of potential sellers decreased somewhat from 2. while only 14 percent of the negotiations were completed from the beginning of the crisis up to April 1998. Vol. In many cases.140 Corporate Governance and Finance in East Asia.

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

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

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. The presence of . some of the potential acquirers demanded terms that were unreasonable or unacceptable from the sellers’ point of view. (ii) to remove cross-guarantees of loans among group members. In effect. 2. the Government and chaebols reached an agreement on the goals of restructuring and reform efforts. Third. (iv) to focus on a small number of core businesses. (iii) to reduce financial leverage. Fifth. and (v) to improve the accountability of controlling shareholders and the board. 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.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. the improved procedures stipulated in the Bankruptcy Reorganization Act and the Composition Act reduced what had previously been legalistic exit barriers. As set forth in the agreement. but it also has important implications with respect to corporate workouts. Seventh.6. Overhaul of Bankruptcy Procedures In February 1998. With this in mind. Sixth. foreign buyers were concerned with the inflexibility of the labor market. many of the businesses that Korean firms put on sale did not prove to be attractive to foreign firms. these goals were: (i) to enhance managerial transparency. Not only does this represent progress in terms of an improved institutional framework for market competition. Second.Chapter 2: Korea 143 course of the Korean economy remains high. local creditor banks were reluctant to absorb losses arising from debt compositions and debt-equity swaps that were necessary in deals involving insolvent sellers. the widespread practice of cross-guarantees of loans and the lack of corporate transparency could potentially give rise to contingent liabilities to the buyer and this has posed a bottleneck problem to the speedy consummation of deals. foreign buyers usually employed discounted cash flow methods of valuation while local sellers often put greater emphasis on replacement costs of assets.

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

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

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

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

II and qualified public corporations. this can only be a temporary measure. as stipulated by the government measure. etc. 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.. then the regulation will inhibit efficient investment of firms. However. the government intervention will have to be refocused so that it only sets the rules of the game in the marketplace. when the limit is binding. considering that there is no other effective way to limit circular investments among chaebol affiliates (e. More important. 2.148 Corporate Governance and Finance in East Asia.6. A investing in B. Direct controls of interfirm investments and/or pyramidal ownership structures will not be persuasive. is inevitable. The corporate governance structure cannot be expected to function efficiently if this issue is not addressed. B investing in C. However. cross-subsidization.) and the level of interfirm investments is very high. the role of the board of directors as the internal control mechanism must loom large in corporate governance. this regulation may not be effective in curtailing pyramidal structures. foreign business corporations with good credit standing are now also permitted to issue ABS. can utilize ABS. As markets become more efficient. Selfdealings. There must be stronger rules to control agency problems. For instance. unless the limit is tight and binding. However.3 Policy Recommendations Poorly performing markets and the resulting lack of market discipline justified the government intervention in recent corporate and financial restructuring activities. One way of strengthening independence of the boards is to require that listed companies accept nominations for directors by institutional . On the other hand.g. and C investing in D. It would be more desirable for the market-oriented measures to be put into place and strictly enforced. Policies aiming to improve the corporate governance system should take into account the high ownership concentration often created by pyramiding. A good governance system is essential for the healthy growth of corporations and financial institutions. Vol. 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. In principle. which is the case for many chaebols. 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. such as the Korea Asset Management Corporation (KAMCO).

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

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

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

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

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

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

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

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

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

2 7.1 4.5 (7.7 Malaysia 9.8 8.8 4.5) 5.5 9.6) 0.158 Corporate Governance and Finance in East Asia. 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. Vol.1 8.9 7.9 6.8 10.9 (1.8 percent growth in fixed 2 The SEC-BusinessWorld Annual Survey of the Top 1.2) 0.2 7. Its growth rate began to catch up with others in 1996.2 Korea.2 Thailand 11.2 During 1988-1997. net sales of the top 1.1).3 9.2 (0.4 Philippines 3.3 8.8 8.7) (10.7 5.2 9.3 9.2) 4.1 GDP Growth of Southeast Asian Countries.4 4. Table 3.2 8. II market.5 percent per year (Table 3.2 Source: ADB. 1990-1999 (percent) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Indonesia 9.0 8. only nonfinancial companies were used. .0 (6. competition from liberalized imports had somewhat reduced oligopolistic tendencies and concentration in many industries. Rep.5) 3.9 5.6 7. Key Indicators of Developing Asian and Pacific Countries 2000.0 7.7 (13. however. The Philippines substantially lagged behind other countries from 1990 to 1995 (Table 3.1 5.3 2. With economic reforms introduced in the 1980s and 1990s.1 5.2 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 1.0 8. of 9.2). This rate of growth was sustained by a comparable 18.000 corporations. only to be unsettled by the crisis of 1997.8 5.3 7. which was taken as a representation of the Philippine corporate sector.0 (0.000 Philippine companies grew 17. 3.5 8. In this section.7 8.000 Corporations covers financial and nonfinancial companies.5 8.8 5.2.7) 10.

5 570.317.0 900 1.3 941.2 707.4 861.1 181 11.5 446.6 290.7 1.4 411.1 4.4 776.000 Companies.5 887 0.7 73 6.9 2.1 54 11. return on assets (ROA) = net income/total assets.5 192. Source: SEC-BusinessWorld Annual Survey of Top 1.5 14.2 27.647.1 72.8 5.3 68 7.1 Other Indicators No.9 3.1 33.4 260.000 Corporations in the Philippines.2 Indicators 1988 Growth Indicators (P billion) Net Sales Net Income Fixed Assets Total Assets Total Liabilities Stockholders’ Equity Retained Earnings 464.6 896 0.3 306.2 2.2 378.177.6 75 6.0 1.191.1 95.6 102 16.978.9 896 2.6 149 12.5 72 7.1 1.5 64.1 6. net profit margin = net income/net sales.5 1.8 22.2 Growth and Financial Performance of the Top 1.0 1.4 8.8 741. .5 1.1 73 5.6 426.1 468.7 1. 1988-1997 1989 519.0 148. return on equity (ROE) = net income/ stockholders’ equity.5 Leverage = total liabilities/stockholders’ equity.8 411.9 96.6 1990 1991 1992 1993 1994 1995 1996 1997 1.8 26.6 900 1.1 1.1 5.209.341.8 77 7.225.6 109 12.4 555.697.9 629.9 480.394.2 4.9 617.3 107 13.2 2.1 66 12.123.3 862. of Companies Sales per Company (P billion) 899 0.131.512.6 35.8 902 1.3 60 10.3 46.1 615.4 63.1 51.9 898 1.4 898 1.2 338.160.6 5.6 18.3 121 12.332.5 1.2 1.Table 3.1 881.781.4 3.1 714.5 508.7 20.4 1.8 618.3 382.8 4.561.8 6.4 188.7 238.7 903 0.5 51 4.893.7 218.2 Average 146 12.6 1.7 28.4 Financial Ratios (%) Leverage ROE ROA Turnover Net Profit Margin 222 14. turnover = net sales/total assets.9 149 6.2 Compound Growth (%) 17.9 952.3 898 1.9 78 6.5 119 12.2 136.6 954.7 443.2 900.1 197 14.5 193.6 144.9 1.4 602.5 4.

5 Ratio of Estimated Value Addeda to GDP (%) 17.4 24.9 21. This is high compared with developed countries but compares favorably with other Asian countries. The growth rates of corporate sales for the period 1988-1997 exceeded those of the country’s GDP for the same period (Table 3.8 17. Further.474 1. Return on equity (ROE) and return on assets (ROA) averaged 12. . The debt-toequity ratio ranged from 222 percent in 1988 to 102 percent in 1994. Assuming Table 3. and by equity that grew at a higher average annual rate of 26. Sources: ADB. These rates of return are high compared with other Asian countries. Net income consistently increased from 1988 to 1996 and declined only in the crisis year 1997.906 2.3 The Corporate Sector and Gross Domestic Product. and the SEC-BusinessWorld Annual Survey of Top 1. Asset growth was funded by debt that grew at an average of 20. indicating that the corporate sector’s exposure to foreign currency-denominated loans was not as significant as in other countries.5 Value-added is assumed to be 30 percent of net sales.8 percent per year. Net profit margins for the top 1.000 Companies Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average Growth (%) a GDP (P billion) 799 925 1.9 percent for the period. II assets.2 percent.1 19.160 Corporate Governance and Finance in East Asia. Vol.7 percent.6 percent and 5.979 17. respectively.248 1. leverage increased from 109 percent in 1996 to 149 percent in 1997. 1988-1997 Top 1.4 20.5 16.427 13. The data suggest no evidence of excessive borrowing in the run-up to the crisis in 1997.394 1.693 1. various years.1 Net Sales (P billion) 465 519 630 741 862 954 1.5 17. Total assets grew at an average annual rate of 22.3).9 23.172 2.077 1.3 percent.178 1.000 companies averaged 7.000 Corporations in the Philippines.8 19. Key Indicators of Developing Asian and Pacific Countries 1999.697 1. for the 10-year period. but the extent of the increase was not as dramatic as in other Asian countries.352 1.

Averaging 42.6 Total Assets 29.9 196 1.8 Growth Indicators (Compound Annual Growth Net Sales 20. and (iv) privately owned.8 ForeignOwned 21.9 22.4 Total Liabilities 26.1 Financial Ratios (%) Leverage 89 ROE 15.8 percent of the corporate sector’s total sales between 1988 and 1997.0 5.5 Source: SEC-BusinessWorld Annual Survey of the Top 1.9 17. (iii) Government-owned.3 11.1 12. size.3 22.4 Stockholders’ Equity 32.7 2.3 27. and industry reveals further structural characteristics of the growth and financial performance of the corporate sector.1 22 10.4 190 5. privately owned companies constituted the largest group (Table 3.0 28.2 103 5.0 Turnover 53 Net Profit Margin 15.8 22. The premise is that these variables have a direct bearing on corporate performance and growth.3 42.8 No. corporate control structure.2 9.4). (ii) foreign-owned. 1988-1997 Indicators Publicly Listed Privately Owned Rate.0 142 22.3 22.1 ROA 8.8 3. these figures suggest a significant and increasing contribution of the corporate sector to GDP.0 31.0 4. A study of company performance by ownership type.3 146 6.5 27.4 28.0 Net Income 19. .7 22.8 606 0.8 14.9 158 13.8 2. Performance by Ownership Type The Philippine corporate sector can be categorized into four groups based on ownership: (i) publicly listed.5 GovernmentOwned 4. various years.4 Growth and Financial Performance of the Corporate Sector by Ownership Type.5 Other Indicators Share of Sales (%) 17.9 26. of Companies 73 Sales per Company (P billion) 2.4 Fixed Assets 19.5 23 4.Chapter 3: Philippines 161 a constant ratio of value added to sales. The foreign-owned companies were the Table 3.5 Retained Earnings 30.000 Corporations in the Philippines.0 5. %) 17.3 9.

although small in number. Privately-owned and Government-owned companies grew at slower rates. the highest net profit margin of 15. Publicly listed companies had a minor though steadily increasing share in total sales. The privately-owned companies had a high average leverage ratio of 158 percent. while there were few of them. but lower than those of foreignowned and publicly listed companies. Bases Conversion Development Authority. II second largest at about 27. and the second lowest asset turnover. compared with P2. Governmentowned companies in the top 1. The privately-owned companies were only about one third of the average size of per company sales of the publicly listed companies. a level high by Western standards but at par with those of other Asian countries. they generated the highest return on investments. registered the largest per company sales at about P9 billion in 1997.3 percent. or 38 percent. foreign-owned companies borrowed more than publicly listed ones. Publicly listed companies had the lowest leverage at 89 percent. selling an average of P4. With an average leverage ratio of 142 percent. exceeding the 17. The compound annual sales growth rate was 21. were among the top 1.162 Corporate Governance and Finance in East Asia. However. the second best ROE and ROA.000 companies in 1997. These were mostly large public utilities.9 percent.5 percent.75 billion per company for foreign-owned companies.000 list. reflecting the significant presence of holding companies as the gross revenues of holding companies flow through to operating income. with an average ROE of 22. . Vol. 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 asset base is large.5 percent average growth rate of the entire corporate sector.2 percent and ROA of 9. Only 84 of the 221 public companies listed on the Philippine Stock Exchange (PSE). 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. Their ROA and ROE were both more than twice as high as those of government-owned companies.1 billion per company in 1997. But by being most efficient in employing assets. these companies were comparatively large. and government-subsidized agencies such as the National Food Authority and Local Water Utilities Administration.8 percent for foreign-owned companies and 20 percent for publicly listed companies during 1988-1997. meaning that the remaining 62 percent were relatively small in sales and assets. and low return on investment is the norm. followed by publicly listed ones.

3 No.0 55. and achieved higher returns on invested assets than independent companies (Table 3. had a lower leverage ratio.7 Stockholders’ Equity 34.Chapter 3: Philippines 163 Performance by Control Structure By control structure. The independent companies contributed about 56 percent of corporate sales on average during the period 1988-1997.6 715 0.6 26.5). the corporate sector is divided into large.1 124 5. 1988-1997 Indicators Group Member Independent 18. of Company 159 Sales per Company (P billion) 2. compared with 32.000 Corporations in the Philippines.0 25. a company can be a member of a conglomerate or independent. Performance by Firm Size By firm size.8 ROA 8.2 Net Income 21. medium. Table 3.8 6.0 22.1 Retained Earnings 32.3 Financial Ratios (%) Leverage 98 ROE 15.3 Total Liabilities 30. depending on assets and sales. and small companies. %) Net Sales 20.2 Fixed Assets 25. grew faster. Sales and resources of the .3 Other Indicators Share in Sales (%) 32.0 Turnover 67 Net Profit Margin 12.0 166 15.2 23.4 24.8 Growth Indicators (Compound Annual Growth Rate.3 percent for the conglomerates.5 Growth and Financial Performance of the Corporate Sector by Control Structure. various years.7 2. But the conglomerates were larger measured in sales per company.1 Source: SEC-BusinessWorld Annual Survey of Top 1.7 Total Assets 32.

1 percent of the total sales of the corporate sector. Vol.1 ROA 5. which.000 list. sales of mediumsized companies grew faster than large companies.0 156 16.9 26. .0 730 0. for this study. 1988-1997 Indicators Large Medium 19. indicating that they deployed resources more efficiently than large and small companies. defined in this study as the next 200 largest companies in the top 1. Medium-sized companies also performed better in terms of ROE.7 44.2 25. of Companies 79 Sales per Company (P billion) 7.9 Retained Earnings 13.9 32. Medium-sized companies. referring to the remaining companies in the list.6 47. various years. II Philippine corporate sector are highly concentrated among the large companies.164 Corporate Governance and Finance in East Asia.5 73 6.5 12.3 Fixed Assets 15.000 list.9 89 1. However.3 Turnover 65 Net Profit Margin 8.4 billion in 1997. averaging 16 percent.2 29.4 28.1 No.1 81 9.6).0 32.3 Source: SEC-BusinessWorld Annual Survey of Top 1. while small companies.6 36.000 Corporations in the Philippines.0 7.6 49.5 Total Assets 18.4 Total Liabilities 18.1 25. averaged a far less P3 billion in per company sales. Large companies accounted for 56.9 Financial Ratios (%) Leverage 158 ROE 13. Sales per company in this group averaged P13.5 128 10.7 Net Income 1.6 Small 19. Table 3.6 31.2 Other Indicators Share in Sales (%) 56.6 Growth and Financial Performance of the Corporate Sector by Firm Size. %) Net Sales 15.2 Stockholders’ Equity 18. averaged only P920 million in per company sales during the same year.8 percent of the total number of companies in the list (Table 3.5 Growth Indicators (Compound Annual Growth Rate.1 4. although they comprised only 8. are defined as the largest 100 companies in the top 1.5 25.

and assets was much higher for the real estate and property. Leverage was the highest for large companies. ROE dropped from 10.. and utilities and services sectors. and equity up to 1996. Growth of sales.5 percent for medium-sized companies and 8. The Asian financial crisis affected large companies most severely.Chapter 3: Philippines 165 Small companies. unlike their counterparts in other Asian countries. and construction.4 percent in 1997 from 11. The growth and financial performance of selected industries. Net income declined from P54.7 percent in 1996 to 8. especially during the period 1994-1996.8 the previous year. although the largest in number. Large. averaging 10.7 billion and P35. with their ROE dropping to 3. compared with 9. i. manufacturing. Medium-sized companies apparently enjoyed efficiencies associated with economies of scale and made more productive use of their assets.1 billion in 1996 to P4. and utilities and services sectors. are shown in Table 3. and profitability in 1997 when the crisis started.1 percent. assets.and medium-sized companies did not substantially increase their leverage in years running up to the crisis in 1997. The sector showed consistent growth in sales. reflecting to some extent a “bubble” phenomena in the former two sectors.2 billion in 1997 for this sector.2 percent for large ones. net income. The real estate and property sector also suffered significantly in sales. ROE dropped to 7. Performance by Industry This study also looked at corporate performance by industry.8 percent in 1997. specifically those industries least and most affected by the financial crisis. The leverage ratio of the manufacturing sector was higher than that of the real estate and property sector. as indicated by the negative annual growth. Mediumsized companies’ leverage level was slightly lower. at -12. profits.7. of net income. net income.6 percent. 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. but lower than that of construction. at 158 percent on average during 1988-1997.7 percent a year earlier. Poor returns appear to have been caused by the low profit margin at 6.7 percent in 1997 for medium-sized companies.e. Sales revenue and net income declined from P76. utilities.8 percent. For small companies. at 156 percent. at 128 percent for the period. and the construction sectors than for the manufacturing. from 14. showed the lowest ROE. but suffered its largest decline in net profits in 1997.8 billion in . real estate.

8 Stockholders’ Equity 21. Vol.4 Total Assets 19.2 37.6 69 16.4 16.8) 17.9 5.7 Growth and Financial Performance of the Corporate Sector by Industry.7 ROA 5.0 23.7 19.9 23.7 10.7 billion in 1997.6 Financial Ratios (%) Leverage 142 181 ROE 13. 1996 to P56.6 Growth Indicators (Compound Annual Growth Rate.4 19. of Company 454 17 Sales per Company (P billion) 1.1 10.5 Other Indicators Share in Sales (%) 82.3 5.7 Net Income (12.9 17. As a result. 1988-1997 Utilities Real Estate and and Services Property 39.4 percent.4 Source: SEC-BusinessWorld Annual Survey of Top 1.7 192 9.1 24 42.000 companies’ total sales on average during 19881997.000 Corporations in the Philippines.8 48.0 31 0.3 20.0 21.3 Retained Earnings 17.9 2.0 25.3 Fixed Assets 20.7 83 2.3 55. various years. .7 percent to 10.4 3. and was also much more limited compared with the property sectors in other Asian countries.2 28 0. The sector’s buildup in equity during the stock market boom of 1994-1996 may have cushioned the impact of the crisis.6 Total Liabilities 18. With a modest increase in total liabilities and leverage level of less than 100 percent in 1997. it does not appear to have been excessively exposed to foreign currency-denominated loans. But the impact of the Asian crisis on the real estate and property sector was much smaller than that on the manufacturing sector.6 No.8 41.0 Turnover 112 24 Net Profit Margin 5. %) Net Sales 16.7 28. the sector’s ROE dropped from 15. Its knock-on effect on the economy was small as it accounted for less than 3 percent of the top 1.7 Indicators Manufacturing Construction 27.9 2.7 52.2 8.2 45. respectively.166 Corporate Governance and Finance in East Asia. II Table 3.5 12.1 2.2 12.9 billion and P24.

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

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

Chapter 3: Philippines 169

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

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

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

Chapter 3: Philippines 171

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

3.3 3.3.1

Corporate Ownership and Control Patterns of Corporate Ownership

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

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

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


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

Chapter 3: Philippines 173

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

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

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

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

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

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

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

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

and Tobacco Holding Companies Manufacturing.3 0.6 0.9 6.6 33.5 4.2 0.0 1. Beverage.3 37.0 5.8 21.6 18.2 0.2 0.3 1.0 0.5 26.7 3.5 53.5 0.0 1.0 1.1 7.0 1.0 0.2 5.2 10.0 0.0 2.0 0.0 5.2 0.2 3.5 4. and Trading Hotel.6 0.0 0.0 0.7 0.7 67.7 3.4 5.2 0.7 0.3 0.0 7.1 5.6 0.8 0.0 1.0 0.9 0.7 0.9 36.1 1.2 3.4 2.0 0.4 29.0 2.3 0.7 1. 1997 (percent) Nonfinancial Investment Nominee Commercial Company Trust Fund Company Individual Bank Government Securities Broker Insurance Company Sector Financial Company Banks Financial Services Average Shareholdinga Nonfinancial Company Communication Power and Energy Transportation Services Construction and Other Related Products Food.0 0.9 0.6 0.0 10.7 0.6 5. .0 0.3 12.7 0.3 0. Recreation.5 2.5 12.0 4.2 1.0 1.2 59.8 0.0 0.3 26.3 5.6 2.0 0.6 9.3 2.Table 3.6 0.5 0.4 0.3 5.3 0.6 2.6 0.1 0.2 3.8 66.4 8.6 12.6 1.1 a Weighted by market capitalization.1 0.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.6 0.0 1.0 45.5 13.1 8.0 1.1 9.1 6.8 0.0 5. and Other Services Property Mining Oil Average Shareholdinga 33.2 3.3 1.4 19.0 0.0 0.0 0.8 11.7 0.9 52. Source: PSE Databank. Distribution.4 1.0 5.

1 percent). and San Miguel Corporation (SMC) in food and beverages.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. Funds of SSS and GSIS consist mainly of compulsory contributions from members of the country’s private sector and government workforce. there was no real market for investment information. These include Philippine Long Distance Telephone Company (PLDT) in telecommunications. . The 7. These are mainly the Social Security System (SSS) and the Government Service Insurance System (GSIS).Chapter 3: Philippines 177 companies and share in the risks and profits of the group.1 percent). accounting for P258. As a group.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. This complex layering of ownership masks the identity of individuals or families that actually own and control operating companies.5 to 12. 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. securities brokers (1. The Philippine capital market did not have an active analyst community comparable to those in more developed capital markets. Holding companies were themselves 66 percent owned by other nonfinancial corporations. commercial banks (1. Insurance companies were very minor investors in the stock market because prudential regulations prevent them from investing significant amounts even in equities of large companies.7 percent of market capitalization of the nonfinancial publicly listed companies. respectively. The investment funds’ presence in these sectors ranged from 8. Petron and MERALCO in power and energy. Investment trust funds were the most important institutional investors. and insurance companies (0. while still allowing the public to own minority shares. The financial institutions among the top five shareholders of nonfinancial corporations are investment trust funds (with 4.3 percent). Holding companies as a sector had the largest market capitalization in PSE in 1997.7 percent of shareholdings). Such advantages have contributed to the popularity of holding companies among publicly listed companies. with an average of only 7. financial institutions did not have a significant ownership in nonfinancial corporations. Because of limited ownership by institutional investors.6 billion or 26.6 percent of market capitalization in 1997. They can also better manage their income taxes because income from affiliated companies passes through a holding company.

178 Corporate Governance and Finance in East Asia. a nonfinancial company that owns a commercial bank has better access to loans at favorable rates and terms. This could further increase the concentration of ownership and expand the scope of own-group lending by these larger banks.6 The total sales of these groups in 1997 were estimated at P806 billion (Table 3. including 16 commercial banks. and increased the capital requirements for all types of banks.8 percent of total companies in number. Foreign banks have a growing presence but have not necessarily increased the supply of credit to the corporate sector. liberalized the regulations on entry of foreign bank branches and foreign ownership of local banks.000 companies. suggesting that business groups are common in all major markets. This is significant considering that there were only 31 local commercial banks in the country in 1997. identified the companies belonging to each of these groups. Most family businesses that went public did so because they wanted to raise capital and to gain the prestige associated with being a public company.11).000 Corporations in the Philippines.000 corporations’ sales. However. Some 20 financial institutions were affiliated with these groups. including SBL and DOSRI rules. Prudential regulations. To understand the ownership and governance characteristics of family-owned business groups. and tracked the financial performance of each company from 1992 to 1997. . More than three fourths of the respondents are either a parent or subsidiary (about 70 percent of these are domestic nonfinancial companies). the Central Bank’s reforms are probably changing the conduct but not necessarily the structure of the banking system. Large shareholders and their families own these banks directly or through their controlled companies. so far limiting their involvement to selected products. suggesting that most publicly listed companies are parts of business groups. the study put together a list of prominent business groups. using data on the Philippines’ top 1. 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. many companies in family-owned groups are not publicly listed. The Central Bank deregulated interest rates and foreign exchange. remain in force to control excessive lending of banks to insiders. Family-based groups have larger companies since their total sales were about 33.4 percent of the top 1. about three fourths. All major industries were represented.7 6 7 The study used publicly available shareholder information and published reports. A common feature of corporate ownership of a business group is the centrality of a commercial bank. Vol. Corporate financing depends on intermediation by banks. but they comprised only 23. For this reason. Commercial banks hold the largest share. of the financial resources in the country. Banks that are members of business groups have an advantage in raising funds from the internal capital market of the group. Still. The process identified a total of 238 companies belonging to 39 business groups from the SEC-BusinessWorld Annual Survey of the Top 1.

000 companies. real estate. Together. Commercial banking contributed about 40 percent of group profits for the Ayala group and Gokongwei group. In terms of sales. the principal owner of SMC. nonfinancial companies contributed about 36 to 60 percent of total profits for these groups. Foreign-owned companies mainly serve the export markets. the nonfinancial sector was real estate (60. the largest was the Eduardo Cojuangco group. and more than 20 percent for the Lopez group and Henry Sy group. Commercial banks are often affiliated to a particular business group. Lopez. and Henry Sy—as examples. To show this. and for the Henry Sy group. broadcasting (49. Gokongwei.000 corporations in 1997. for the Gokongwei Group. It is also noteworthy that.12). for each of these groups. the largest family-based business group was the Ayala Corporation Group. an average group in the Philippines has fewer member companies.Chapter 3: Philippines 179 Compared with other Asian countries. The significance of family-based business groups in the Philippine corporate sector is immediately evident in the 50 largest corporate entities. a substantial proportion of group profits came from its financial subsidiaries. For the Ayala group.6 percent of the total sales of the top 1. and Ayala. as discussed in previous sections. with 27 affiliated companies in the top 1.8 percent). construction.2 percent). with the exception of Banco de Oro. including business groups and independent companies. In terms of number of companies. The main constraint may be the availability of family members that could be drawn for top management positions. the top 10 family-based business groups had only 119 companies in the top 1. in most .4 percent of the group’s 1997 profits). the biggest private company in the Philippines.000. it was manufacturing (36. In the meantime. the three largest entities were family-based groups. retail merchandising (69. the two were closely related through their affiliations to business groups. 25 out of the 50 top corporate entities were familybased groups. which was majority-owned by the Henry Sy group. Cojuangco. Family-based business groups are most dominant in sectors such as manufacturing. and banking. for the Lopez group. the study used the four largest business groups—Ayala. In 1997.1 percent). 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. Lopez. or an average of about 12 per group. namely. Significantly. ranged according to their sales (Table 3. Also. These corporate entities accounted for 53.

0 17. beverages.5 17. 16.5 47.0 13.2 16. food. 8. Flagship Company.2 1. and mining Management. coconut oil. 14. agriculture.6 3.3 3. 17.6 7. and Affiliated Bank of Selected Business Groups. of Affiliated Companies Total Sales (P billion) 123.9 2.6 2. 2.4 48.0 26.1 2.5 49.4 10.5 44. telecom. 4.3 15.4 .11 Total and Per Company Sales. 1997 Business Group 19 15 27 12 12 9 4 6 11 4 8 9 5 4 5 6 Major Sector Orientation Estimated No.5 26. real estate. construction. Beverages.2 1.3 2. beverages.Table 3. 5. 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. 3.1 4. and food Food. 13.7 98. Eduardo Cojuangco Lopez Family Group Ayala Corp. power. Sector Orientation. and packaging Power distribution and mass communications Real estate.1 4. and personal care prods Shipping.5 13. 7. 9.5 46. 15.6 3.3 11.4 6.8 84.9 3. and tobacco Telecommunications Cement and construction materials Pharmaceutical and distribution 12. and dairy products Investments.0 5.5 2. 11.0 Average Sales Per Company (P billion) 6.5 6. food. 10. and tourism Credit card 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 Wilfred Uytengsu/ General Milling Group David M. Real estate. 6.

Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. and various company annual reports.2 4.6 3. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/ Fil-Estate Group Total Real estate Sources: PSE Databank. P.7 0.9 1. 30. 27.0 2.3 2. 29.5 8.3 2. 24.6 0. and real estate Department store Mining Construction Telecommunication Shipyard and power 4 7 5 2 4 4 3 2 5 7 5 5 2 3 2 3 2 2 2 2 8.7 1.7 3.7 4. 31. 28.0 1.9 0.1 1. mining. 35. 20.1 2.8 1. 26.7 0.0 0. .6 2. 33. 39. 22. 36.3 7. distribution.19.7 0.0 5.000 Corporations (1997). Ramos Gaisano Family Group Felipe Yap Felipe F.1 1.6 Fast food Beverages and agro-industrial products distribution Cement and wood products Retail merchandising Electronic appliances Real estate Mining Real estate Telecommunication.8 1.9 1.9 7. 38.8 1. 37.4 1.9 1.9 0.4 5. 21.4 3.1 0. 25.9 6.2 6. 23.8 6.4 3. and real estate Retail merchandising Ceramics and real estate Department store and real estate Cement and sugar central Real estate and securities trading Bookstore. 4 238 1.8 Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J.2 1.6 5. 34. 32.5 2. SEC-BusinessWorld Annual Survey of Top 1.1 805.

Sector Orientation. 1. 14. 4. 15. 3. 8. 13. 17. 19. 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. 20. 5.11 (continuation) Total and Per Company Sales. 7. 9. Flagship Company. Long Distance Telephone Phinma Zuellig Pharmaceutical Metro Pacific William Gothong and Aboitiz Swift Foods/RFM House of Investment Anscor Equitable Card Network Inc. 18. Eduardo Cojuangco Lopez Family Group Ayala Corp. and Affiliated Bank of Selected Business Groups. 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. Alaska Milk Corporation DM Consunji. Uytengsu/General Milling Group David M. 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. 6. 12.Table 3. 10. 21. 11. Inc. Jollibee Foods Corporation Pepsi Cola Products Alsons Cement . 16. 2.

Inc. 31. a b Size class is measured in terms of sales: Large = greater than P4. 26. 38. 28. Cruz & Co. Kepphil Shipyard Inc. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/Fil-Estate Group Medium Medium Small Medium Medium Small Small Small Small Medium Small Medium Small Small Small Small Small Small Rustans Solid Group Filinvest Philex Mining Megaworld Properties Jaka Investment Corporation Uniwide Corporation Guoco Ceramics Ever Gotesco Republic Cement PhilRealty National Bookstore Gaisano Department Store Lepanto Consolidated Mining F. small = less than P1. PT&T Corp. 22. P.East-West Bank International Exchange Bank Ecology Bank (Savings Bank) Dao Heng Bank Orient Bank International Exchange Bank International Exchange Bank Philbanking Corp. F. 37. 32. Keppel-Monte Bank Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. 27. Fil-Estate Development Inc.48 billion. . unless otherwise indicated. 34.48 billion. 30. Sources: PSE Databank.65 billion.65 billion to P4. Refers to commercial banks.. and various company annual reports. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C.000 Corporations (1997). Ramos Gaisano Family Group Felipe Yap Felipe F. 25. medium = P1. 36. 23. 39. 29. 35. SEC-BusinessWorld Annual Survey of Top 1. 24. 33.

1 60. 16. 19. food. Fujitsu Computer Products Corp. Inc. and packaging Power distribution. construction. 3. and telecommunications Department store and banking Airlines.4 19.5 26. 1997 Sales (P billion) Control Structure Major Industrial Orientation 123. 24.8 84. 5. of the Phils.5 46.3 15.7 98. Texas Instruments (Phils.). 18. Inc. 22. food. 13. Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Philippine Associated Smelting and Refining Corp. agriculture. 6.0 24.5 17.0 38. 7. Del Rosario/PHINMA Zuellig Group Toshiba Information Equipment (Phils.).6 18.5 77. banking.2 49. car manufacturing. 23.6 26. 11. 9.8 22. 4. 12.5 47. and personal care products Shipping. 17. and car manufacturing Power Refined petroleum products Refined petroleum products Banking. 2. First Pacific/Metro Pacific Group 21.2 16. Philippine National Bank Mercury Drug Corp. 20. beverages.5 15. and bank Real estate.Table 3. Beverages. and tobacco Telecommunications and banking Refined petroleum products Radar equipment and radio remote control apparatus Cement and construction materials Pharmaceutical and distribution Electronic data processing equipment and accessories Electronic data processing equipment and accessories Bank Drugs and pharmaceuticals goods retailing Real estate. and dairy products Investments. beverages.4 48.1 17. 10. Petron Corporation Pilipinas Shell Petroleum Corporation George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Caltex (Philippines) Inc.0 37.5 44.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. telecommunication. and mining Gold and other precious metal refining . food. 15.2 Business Group Business Group Business Group Government. 8. coconut oil. Eduardo Cojuangco Lopez Family Group Ayala Corporation Group National Power Corp.8 53. and food Food. power. 14. and real estate Banking. mass communications. bank.12 Control Structure of the Top 50 Corporate Entities.

45. 48. Corp. 36.7 13. 9. and other grains wholesaling Other amusement and recreational activities Motor vehicles Food and dairy products Construction and mining Television and radio transmitters.4 10. 44. Amusement and Gaming Corporation Mitsubishi Motors Phils.5 10.8 9. 50.8 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 38.9 7. 31. 35. National Steel Corporation National Food Authority Phil.0 11.0 5.6 9.290 53.3 13. Inc.A.000 Companies Sales (%) Cigarettes Bank Soap and detergents Management. 32. radio and remote control apparatus Fast food Bank Beverages and distribution of agro-industrial products Drugs and medicines. and tourism Banking Radar equipment and radio remote control apparatus Operation of rolling mills Palay. Inc. 33. 29.0 12. 47.. real estate. 46.2 7.9 7. corn (unmilled).6 12.7 10. Philips Semiconductors Phils. 41. 26. EAC Distributors Inc. and various company annual reports. 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 1.6 1. 30.5 8. 39.9 14. Consunji Uniden Philippines Laguna. 27.5 8. Uytengsu/General Milling Group David M.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.7 10. . 49. 42. 37. Philip Morris Philippines.25.3 8.000 Corporations (1997). Inc. 40.8 6.4 8. and apparatus for line telephony and line telegraphy Tobacco products wholesaling Cigarettes Radar equipment. 34.0 13. including biological products Bank Cement and wood products Retail merchandising Electronic appliances Mining Real estate Sources: SEC-BusinessWorld Annual Survey of Top 1. 14.1 9. PSE Databank. W. 28. Jollibee Foods Citibank N. 43.9 6.

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

Making day-to-day management decisions was not regarded as an important board responsibility.Chapter 3: Philippines 187 actual practices of board functions and the role of shareholders may diverge somewhat from the legal framework. appointing senior management. with a maximum of 36 percent.7 percent). protecting shareholder interests. In a few cases. Such a short tenure may to some extent suggest that large shareholders want to keep their board members under close control. More than half of respondents indicated that board directors were elected during the shareholder general meetings. a fixed fee plus performance-related bonuses (30 percent). or a per diem for meetings (18 percent). In practice. According to the ADB survey. This can partly be explained by the fact that many family-based large shareholders control companies through holding companies in which they have majority ownership. a typical chairperson owned 3 to 5 percent of outstanding shares of a company on average. the average number of years of holding office was 6. Financial compensation is another means by which shareholders can motivate boards and board members to manage companies in their interests. or representatives of creditors. The ADB survey results show that a chairperson is compensated either by a fixed fee (52 percent of respondents). The majority of respondents indicated that board directors and chairpersons were elected mainly on the basis of either relationship with major shareholders (31. and determining remuneration for board directors and senior management. or percentages of shareholdings (28. or the Government without approval by shareholder general meetings. . Respondents of the ADB survey ranked the following as the most important responsibilities of the board: making strategic decisions.9 percent).7 percent). ensuring that a company follows legal and regulatory requirements. The average stipulated term of office of the chairperson and members of the board for most responding companies was one year. But half of respondents indicated that they also had board directors directly nominated by controlling shareholders or management.6 for board chairpersons and 7.5 for board members. But professional expertise is also an important criterion (28. The longest was 27 years for board chairpersons and 14 years for board directors. in a descending order. The ADB survey shows that the number of board directors ranged from six to nine among the responding companies. appointed by the Government. Board chairpersons in a substantial number of responding companies did not own significant amounts of shares in their personal capacities. board directors were the founder of a company.

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

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

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

An average of 327 shareholders per company attended the last annual meeting and they represented about 63 percent of total shares.13 ADB Survey Results on Shareholder Rights Percentage of Respondents Shareholder Rights One Share One Vote Proxy Voting by Mail Preemptive Rights on New Share Issues Prohibition of Loans to Directors Mechanisms to Resolve Disputes with Company Independent Audit Mandatory Independent Board Committees Severe Penalty for Insider Dealings Source: ADB Survey of Philippines Publicly Listed Companies. Nominees held about 45 percent of the outstanding shares.4 70.2 7.8 56. About 333 shareholders per company voted by proxy. The responding companies had on average 43.4 No 0. Yes 100. Table 3. demonstrates the feasibility of developing a market for corporate control if publicly listed companies were widely held. The ADB survey provides further evidence on shareholder rights. 1999.7 43. a company that is widely held but has a large shareholder.0 63.2 69.522 shareholders each.0 51. An average of about 4. appointed either by the board or shareholders during the annual general meetings. protection.6 Independence of Auditing The ADB survey revealed that all the responding companies had an independent auditor. representing 3.8 92. The brokers or securities companies were the most important proxy voters.4 percent of shareholders but 58 percent of outstanding shares. followed by management and banks.13 summarizes rights that the shareholders of the responding companies enjoyed. About 93 percent of the respondents contracted .Chapter 3: Philippines 191 in a few controlling shareholders and families.900 shareholders per company did not vote during the last annual general meeting.8 30.2 43.0 36. representing about 24 percent of outstanding shares. Table 3.0 48. the successful hostile takeover by First Pacific Group of PLDT. Nevertheless.6 30. and their activism in the corporate sector.3 56.

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

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

These investments can be classified according to the role of the controlling shareholders in the management of the invested company. minority control at 42. The stylized features of control structure of business groups in the Philippines can be illustrated by using a leading Philippine family-based conglomerate. Public investors collectively hold a minority of 41 percent. This is most evident when a minority-owned company transacts with other members of the group where the controlling shareholders hold majority control.4 percent of Bank of the Philippine Islands. especially its management.194 Corporate Governance and Finance in East Asia. the parent company plays an active role in management. II equity investment for public listing. In an active minority-owned operating company. Honda Cars (Philippines). Controlling shareholders gain additional leverage in management control over minority-owed companies. and a passive minority investment at 15 percent in Honda Cars (Philippines).1 percent of Ayala Land.6 percent of Globe Telecom. of Cebu Holdings (a publicly listed government-owned company). controlling shareholders of the parent company may eventually increase their shares to a majority position. controlling shareholders of a parent company hold these shares as “strategic investments” that they could increase or reduce depending on business opportunities. and customers. The first three companies are publicly listed while the fourth. Vol. 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. Ayala Corporation’s majority. as an example (Figure 3. Minority-owned companies may also need access to resources of the group.1). at 47.2 percent. an active minority share at 44. financing. .and minority-controlled operating companies are also holding companies. Ayala Corporation is a publicly listed pure holding company. It has a majority control at 71. namely. They may have a representative in the board. with 59 percent of shares. Ayala Corporation then holds a sufficient number of shares to achieve various degrees of control in two types of holding companies and two types of operating companies. It is majority-owned by Mermac. In a passive minority-owned operating company. Ayala Corporation. controlling shareholders of the parent company do not participate in management. In cases of minority ownership. Some holding companies are not pure holding companies. a family-owned pure holding company. is privately owned.. Inc. They are operating companies but at the same time have majority or minority share ownership in other operating companies. Depending on the performance of the company. active minority or passive minority holdings.

Inc.6%) <15% Passive MinorityOwned Pure Operating Company Honda Cars Phils.Figure 3. Inc.96%) Privately-Held Pure Holding Company Public Investors (41..1 Corporate Control Structure: The Case of Ayala Corporation Family Members 100% Mermac. .06%) <50% >15% &<50% Active MinorityOwned Pure Operating Company Globe Telecoms (44.2%) >50% MajorityControlled Pure Operating Company BPI Family Savings Bank (100%) <50% MinorityControlled Pure Operating Company Note: Data as of 31 December 1998.44%) >50% MajorityControlled Pure Operating Company Makati Development Corporation (100%) <50% MinorityControlled Pure Operating Company Cebu Holdings.04%) <50% Ayala Corporation >50% Publicly Listed Pure Holding Company >50% MajorityControlled Operating and Holding Company Ayala Land (71. (15%) MinorityControlled Operating and Holding Company Bank of the Philippine Islands (42. Inc. (47. (58.

98% x 42. Being in the public utilities sector.76%)] [39. The situation offers large shareholders tremendous incentive to move resources 10 For details. MERALCO. and Larry H. P. and First Philippine Industrial Corporation are indirectly held by a majoritycontrolled holding company. Benpres Holdings. P.7 times its cash flow rights by virtue of its cross-holdings via Benpres and First Holdings. and a minority-controlled holding company. [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. and Larry H.2).7 times Ibid. Simeon Djankov.7 times 12 .14%] / [6. and 1999c.12 These examples show that even when large shareholder groups are minority shareholders.8%] 5. 1998.5% x 14. is illustrated in the Lopez Group (Figure 3. H. Diversification and Efficiency of Investment by East Asian Corporations.10 The Ayala family’s control rights over BPI was 1. II Bank of the Philippine Islands owns 100 percent of the BPI-Family Savings Bank.5%] / [(88. Simeon Djankov. Generally. 1999b. First Philippine Holdings Corporation. Fan. however. indirect shareholdings do not appear to be a prevalent practice in the Philippine corporate sector. See also Stijn Claessens.44%] / [25%] = 1. companies in the Lopez Group are large and minority-controlled. Lang. defined as control by large shareholders of an operating company through minority ownership by several companies.11 The Lopez family’s control rights over MERALCO was 5. Lang: 1999a. Expropriation of Minority Shareholders: Evidence from East Asia.3% x 5. see the World Bank research papers by Stijn Claessens.44%] = [42.5%] [39. [control right] [control rights via Ayala Corporation] = [cash flow right] [cash flow rights via Ayala Corporation] = [42. Joseph P.7 times its cash flow rights by virtue of the double layer pyramid structure of the Ayala group. 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. Vol.196 Corporate Governance and Finance in East Asia.44%] / [58. The control of companies through indirect corporate shareholdings. a privately owned company. Who Owns and Controls East Asian Corporations? 11 Ibid. they exercise far greater control (two to five times more) than they are entitled to by virtue of their ownership rights. Rockwell Land.14%] / [1.64%) + (37. The Separation of Ownership and Control in East Asian Corporations.3% x 1.64% +37.

3% 11. Inc.2 Corporate Control Structure: The Case of Lopez Group Public Investors Family Members Lopez.76% Operating Company MinorityControlled 24.5% First Philippine Industrial Corporation 50% 50% Note: Data as of 31 December 1998.64% MinorityControlled 14.5% Minority-Controlled Publicly Listed Pure Holding Company First Philippine Holdings Corporation Benpres Holding Corporation Majority-Controlled Publicly Listed Pure Holding Company Manila Electric Company 1.5% Operating Company MajorityControlled Operating Company Rockwell Land Corporation 24.7% 62. .Figure 3. Privately-Held Pure Holding Company 88.

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

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

compared with other economies. Foreign portfolio investments also remained small. compared with Malaysia ($186 billion).4 billion (or $59 million using the average exchange rate). Equity financing through IPOs was active. but not to the same extent as it did in other Asian economies. companies expanded only at a moderate pace. Korea and Thailand). about the size of Thailand’s. and less engaged in risky investments.200 Corporate Governance and Finance in East Asia. Most companies invested only in projects that met hurdle rates as high as 20 to 30 percent and had short payback periods. Equity instruments include common stocks. The corporate sector raised a substantial amount of . preferred stocks.5 billion). The Government financed its chronic fiscal deficits by issuing short-term Treasury bills. From the 1970s up to the early 1990s. is far ahead of the flock. Of the 221 companies listed in the Philippine Stock Exchange in 1997. They invested in only a few large companies whose shares were relatively liquid. Foreign funds were wary of the Philippine stock market because of its limited liquidity. Vol. this is because. the minimum required to qualify as a public corporation. only 84 had sales large enough to be placed in the top 1. The market capitalization of the Philippine stock market in August 1997.000 companies. and fiscal management were among interrelated factors explaining the underdeveloped state of the Philippine financial market. Malaysia. However. the Republic of Korea (henceforth. Most publicly listed companies issue only up to 20 percent of total shares to the public. and Indonesia ($61.14 shows that the average volume of daily trading in 1997 stood at P2.g.. less exposed to foreign debt. the country experienced double-digit inflation. II sector. inflation. Korea) ($143 billion). was one of the smallest in the region at $47. Even in the real estate sector. The stock market was depressed up to the early 1990s. Table 3. Philippine companies were less leveraged. most listed companies are controlled by their five largest shareholders. In part. As a result. The Philippine stock market is not a liquid market. and convertible securities. The period 1993-1997 was one of lower inflation and declining lending rates. 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. especially short-term debt. however. The crisis affected the Philippine corporate sector.7 billion. Interest rates. Rising stock prices during the Ramos administration reflected to some extent the business optimism. while interest rates were at high levels and volatile. 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.

1 524. . Source: PSE databank.3 0.3 158. P billion) 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 19.8 102.251.6 1.14 Philippine Stock Market Performance.4 9.1 0.692.0 0.6 1.7 207.5 1.1 0.1 0.2 925.1 0.2 ($ million) — — — — 6.9 114.3 0.686.9 2.3 — = not available.9 1.2 0.2 0.7 2.Table 3.351.6 261.5 16.8 0.2 1.474.2 57.545.088.121.2 297.3 4.0 2.373.5 72.7 1.386.9 2.0 161.4 Ratio of Market Capitalization to GDP 0.248. 1983-1997 Daily Trading Volume (P million) — — — — 129.515.9 682.2 1.5 1.0 0.1 5.7 0.5 12.445.906. P billion) Gross Domestic Product (current prices.2 59.3 314.8 799.8 1. Note: Combined transactions of Makati and Manila Stock Exchanges are not available for the years 1983 to 1986.171.9 608.4 1.7 391.7 41.8 1.5 26.2 61.5 571.421.3 Market Capitalization (year end.1 88.3 2.5 Year 369.9 12.3 59.0 0.2 3.8 1.077.4 728.0 1.

2 Patterns of Corporate Financing The study looked at retained earnings. leases. which ultimately influences the pricing of commercial paper issues. The corporate bond market was stunted.4.6 billion. about 127 companies went public with a total value of offerings of about P134. which in most cases is an affiliate of the issuing company. which buy commercial papers either for their own account or for their clients.202 Corporate Governance and Finance in East Asia. Few companies offer preferred stocks because the Philippine tax system does not allow tax deductibility of dividends on preferred stocks. by volatile interest rates and the absence of a secondary market. 3. which were the principal source of corporate financing in the Philippines. The measures used in the analysis are: . moreover. The underwriter. II equity capital through IPOs during the stock market boom from 1993 to the first half of 1997.. of which 85 percent was raised from 1993 to the first half of 1997. Vol. include bank credits. because business groups often own large commercial banks. issuing companies had to undergo a process of review and credit rating by the Credit Information Bureau Inc. However. sells these commercial papers through brokers. are in a position to provide such discipline. and inventory financing. Corporate bonds are another type of debt securities. and debt as sources of corporate financing by using flow of funds analysis. a strong regulatory system for bank supervision is imperative. Because existing shareholders wanted to retain their proportionate control over their companies. This is because only companies with strong capitalization and predictable cash flows such as public utility companies can issue bonds. asset-backed credits. Negotiated credits. Only the commercial banks. by virtue of their large stakes in the financial system. Debt instruments include negotiated credits and debt securities. new equity. From 1988 to 1997. corporate bond issuing was even more limited. Debt securities include commercial papers and corporate bonds. The largest buyers have been commercial banks. discounting of receivables. Under SEC regulations. the rights issue was a popular way of raising equity capital. and the dominance of large commercial banks. Capital markets cannot provide the market discipline that corporate investors need. lack of competition among financial institutions. However. The picture of the financial system that emerges is thus one of limited capital markets. and high transaction costs. tight regulations. Only a few large companies floated commercial papers because of the limited market.

By definition.1 0. Self-financing ratio of total assets (SFRT): ratio of changes in retained earnings to changes in total assets. . Retained earnings were sufficient to finance the entire growth of fixed assets in the corporate sector.1 0.8 0.7 0.0 0.4 0.5 0.15. during this period.1 0.5 0. It measures a company’s reliance on borrowings in financing asset growth.000 Corporations in the Philippines from 1988 to 1997.4 1.3 0. 1989-1997 Financing Indicators SFRF SFRT NEFR IDFR IEFR 1989 1990 1991 1992 1993 1994 1995 1996 1997 1.3 0. Incremental debt financing ratio (IDFR): ratio of changes in total liabilities to changes in total assets. All Companies Financial flows data were derived from the SEC-BusinessWorld Annual Survey of Top 1. As shown in Table 3.4 0.4 0.2 0.6 0.5 0.9 0.6 0. Incremental equity financing ratio (IEFR): ratio of changes in shareholders’ equity inclusive of retained earnings to changes in total assets. It measures a company’s capacity to finance growth in fixed assets by internally generated funds.4 0. On the other hand.1 0. it is one minus IDFR.5 0.3 0.3 0. It measures a company’s capacity to finance asset growth by equity capital.3 0. It measures a company’s capacity to finance asset growth by internally generated funds.9 0.2 0.5 0.8 0.1 Average 1.9 0.4 0.5 0.4 0.2 0.5 0. 1988-1997.1 0.3 0.0 0. the SFRT was low at Table 3.4 0. New equity financing ratio (NEFR): ratio of changes in stockholders’ equity (excluding retained earnings) to changes in total assets.15 Financing Patterns of the Corporate Sector.5 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.3 0.5 2.6 0. the average SFRF was high at 109 percent.8 0.2 0.5 0.9 0.000 Corporations in the Philippines.5 Source: SEC-BusinessWorld Annual Survey of Top 1.2 0.

As a result. with debt providing 93 percent of the financing requirements. In all the years. The corporate sector used new equity to finance 32 percent and new debts to finance 49 percent of growth in total assets.5 0.and foreign-owned. 1991.5 Privately-Owned 0. II only 19 percent. This was mainly caused by the declining contribution from retained earnings.0) 0. In periods of an economic crunch such as in 1989.204 Corporate Governance and Finance in East Asia. and 1997. 1989-1997 Financing Indicators SFRF SFRTa NEFR IDFRa IEFRa a Publicly Listed 1.5 Foreign-Owned 1. In 1997. except for foreignowned companies that had a negative new equity financing ratio.2 (0. when it financed 45 percent of it. privately. There were significant year-to-year variations. internal funds were not a significant source of financing growth in total assets.3 0. Companies financed fixed assets from internal sources in hard times. 1988-1997.3 0.000 Corporations in the Philippines. Vol. The corporate sector consistently relied on debt and new equity to finance asset growth throughout the period. 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. suggesting that there was a deterioration of financial performance in the Philippine corporate sector in the years running up to the crisis. reflecting the capital flight caused by political instability in the early 1990s. Corporate Financing by Ownership Type As shown in Table 3.1 a Excludes negative balances.9 0.16.8 0. the level of corporate leverage increased. except in 1991.3 0. Retained earnings were the least important.6 0. retained earnings declined and few new equity investments flowed into the corporate sector.16 Corporate Financing Patterns by Ownership Type.3 0. debts were the most important source of financing. . for all three types of companies—publicly listed. implying that internal funds were far from sufficient to finance growth in total assets. Total assets grew by 23 percent that year. On Table 3. the SFRF was higher.7 0.2 0. Source: SEC-BusinessWorld Annual Survey of Top 1.

.7 7.1 50.8 26. compared with 47 percent for publicly listed companies and 55 percent for privately-held firms.2 42.6 26.8 51.3 4.0 Source: SEC-BusinessWorld Annual Survey of Top 1.7 2.9 24.2 3.9 0.5 27.5 9.4 100.3 13.0 6.9 12.6 48.2 100.0 13.9 16.1 49.2 3.5 12. significantly Table 3.4 2.9 16.1 7.2 12.0 8.17.9 4.0 1994 19.6 37.8 3.7 23.4 100.6 48. The sector built up its short-term debts.9 100.0 12.0 10. contributing 90 percent of growth in total assets. It presents a composition analysis of assets and financing sources for the period 1992-1996.5 16.0 38. A breakdown of the financial structure of publicly listed companies measured in balance sheet items is shown in Table 3.8 0.7 13.3 10.4 100.5 41.17 Composition of Assets and Financing of the Publicly Listed Sector.4 3.0 9.9 3.Chapter 3: Philippines 205 average.7 100.8 0.7 2.3 51. 1988-1997.8 4.3 12.8 38.1 9.3 11. especially bank loans.8 17.2 100.and foreign-owned companies.6 43.0 100.0 10.7 13.4 43. publicly listed companies relied more on new equity financing than privately.8 46.8 39.1 13.8 100.6 0.4 12.0 9.000 Corporations in the Philippines.8 3.3 12.3 12.4 41.0 9.3 10.0 1995 1996 13.0 9.0 53.9 16.2 51.8 16.5 0.4 10. Foreign-owned companies relied more heavily on debt financing.1 10.7 4.1 15.4 2.0 1993 14.9 38. 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 14.3 48. This financing pattern supports the earlier finding that foreign-owned companies had the highest leverage among the three types of companies.4 100.

3 0. .5 0. The normal standard liquid position is a current ratio of 2 or higher.13 was at 1.6 Independent Company 0. On average.2 0.5 0.3 0. The traditional measure of liquidity. Group companies were generally more profitable than independent companies.45 in 1996. their inherent ability to pool risks.18 Financing Patterns by Control Structure. As shown in Table 3. compared with an average of 54 percent for independent companies.9 0. Further. Vol.3 0. Corporate Financing by Control Structure Conglomerates have certain advantages in financing because of the opportunities offered by the internal capital markets. for independent companies. and economies of scale in fund raising. the current ratio.5 Excludes negative balances Source: SEC-BusinessWorld Annual Survey of Top 1. as opposed to 94 and 30 percent. The SFRF for independent companies would have been even lower if the highly profitable foreign-owned companies were excluded. Table 3. 1988-1997.1 0. indicating that many publicly listed companies were likely to be in a tight liquidity position. For these two reasons.206 Corporate Governance and Finance in East Asia. the average SFRF of business groups was higher compared with that of independent companies.18. the easier access to external credit. Group companies financed an average of 45 percent of growth in total assets by debt. II in 1996 and became more vulnerable to the financial crisis in 1997. respectively. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Group Member 1. 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.000 Corporations in the Philippines. group companies were less reliant on debt financing than 13 Defined as total current assets divided by total current liabilities. group companies usually financed their investment in member companies by equity rather than debt.

6 0. Corporate Financing by Industry The manufacturing sector had an average SFRF of 1. equity financed 42 percent of incremental asset growth. The corresponding ratio was 0.2 0.3 0. Corporate Financing by Firm Size SFRF was highest for medium-sized companies.19).2 0. These years were 1991 with 110 percent. with an average of 3. and 1997 with 131 percent.3 0. The medium-sized companies’ high debt financing ratio was due mainly to three years of complete reliance on debt to finance growth.19 Financing Patterns by Firm Size. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Large 0.47. 1993 with 96 percent.08 and SFRT of 0.88 for large companies (Table 3. Large firms consistently increased their reliance on debts from 1994 to 1997.9 0. medium-sized companies used more debts.1 0.20). compared with 55 percent for large companies and 47 percent for small ones. Source: SEC-BusinessWorld Annual Survey of Top 1. The lower SFRF for large companies may be caused by their larger outlays for growth in fixed assets.76 for small companies and 0. Excluding .2 0.Chapter 3: Philippines 207 independent companies.55 was substantially higher than the small companies’ 0. averaging 61 percent of growth in total assets. There was also increased reliance on debt financing.000 Corporations in the Philippines.6 0.5 Medium 3.8 0. On average. With assets growing at a fast pace during this period. 1988-1997.5 0. These results support the earlier finding that the leverage of business groups was lower than that of the independent companies from 1988 to 1997.5 Excludes negative balances.50 (Table 3. Table 3.3 0.4 Small 0.06. Large companies’ IDFR of 0.

5 Utilities and Real Estate Services and Property 0.29. .4 3.5 (0. The real estate industry financed its growth by substantial equity funds.1 0. Since the real estate boom coincided with that of the stock market.58 and SFRT of 0.4 0. Source: SEC-BusinessWorld Annual Survey of Top 1. when debts declined. achieving an average SFRF of 3. 1988-1997. Table 3.3 0. many of the leading real estate companies successfully went public during that time.3 0.20 Financing Patterns by Industry. Up to 1997.2) 0. SFRF for the sector averaged 0. Its SFRF and SFRT were volatile because of chronic losses and reduction in fixed and total assets.6 0.3 0. II 1991.04. In the eight years preceding the crisis. with an SFRF as low as 0. The sector had the highest leverage among all industries that year.5 0.4 Construction 0. The situation improved beginning 1994. Vol.6 0. Low incomes diminished the equity financing position of the manufacturing industry toward the crisis year. Equity financed the rapid expansion in the industry’s assets in the period 1994 to 1997.27.6 0. Equity financed an average of 62 percent of total asset growth.7 0.4 0. Total liabilities increased partly as a result of the local currency devaluation and financed all of asset growth for the year. Excluding 1997 when fixed assets declined.32.6 a Excludes negative balances. The construction sector was a heavy user of debt financing. the total debt ratio was much higher in 1996 at 0.208 Corporate Governance and Finance in East Asia.79 and in 1997 at 0. increasing to 0.47 two years later. Incremental equity financing amounted to an average of 44 percent of total asset growth. The utilities sector showed weaknesses in internal fund generation in 1989-1994. while SFRT averaged only 0. ranging from 41 to 118 percent. the industry generated internal funds.4 0. The effects of the crisis of 1997 were adverse. the manufacturing industry financed 57 percent of its total asset growth by debt.91. During the crisis year.000 Corporations in the Philippines. 1989-1997 Financing Indicators Manufacturing SFRFa SFRTa NEFR IDFRa IEFRa 1. the incremental equity ratios of the industry were high.5 0.3 0. While this level is considered prudent. debt financed about 78 percent of asset growth in real estate.

as the dependent variable.3 Ownership Concentration. These results suggest that companies with higher ownership concentration tend to be more highly leveraged and.130 ROA 0. ROA = return on assets. and leverage. ROA. As shown in Table 3. Profitability. ROE = return on equity. knowing that if an investment turns out to be successful they could capture most of the gain. measured by the percentage of shareholdings of the largest five shareholders. Exit.Chapter 3: Philippines 209 3. creditors bear the consequences. Large shareholders may also overuse financial leverage to avoid diluting ownership and control. Source: Author’s estimates based on the PSE databank.00125 2. 1992-1996.860 Leverage = the ratio of total assets to total equity. Three regressions were run with the shareholding of the largest five shareholders as an independent variable and ROA.004 3. and the Failure of Internal Control Systems. ROE. Journal of Finance 48: 831-880. and Financial Leverage Dependent Variable Item Coefficient of Ownership Concentration T-statistics Adjusted R-squared F-statistics ROE 0. at the same time. 14 See for example Michael Jensen (1993). The Modern Industrial Revolution.287 0. Table 3. and Performance Previous studies on corporate governance have often associated ownership concentration with heightened risk-taking by companies.008 5.4. ROE. Using the PSE database. the degree of ownership concentration.009 5. and financial leverage are all positively and significantly related to the degree of ownership concentration. . ownership concentration = the total shareholdings of the top five shareholders.00036 2.230 Leverage 0. more profitable.00056 1. the coefficient of the ownership concentration measure in all the three regressions is positive and statistically significant.421 0. was regressed against measures of profitability and of financial leverage.14 Large shareholders may borrow excessively to undertake risky projects.21. Financial Leverage.21 Ownership Concentration.769 0. while if it fails. alternatively.

About 80 percent of imports were capital goods (particularly power generating and telecommunications equipment). which averaged 4. Although much lower than those of other Asian countries. The Government explained that the country had “sound economic fundamentals” but that the problems were caused by “contagion.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. the economy still showed vestiges of its import-dependent and substituting character. more than half (52 percent) of exports were semiconductors. Historically. raw materials.5 billion in 1996 and grew at an average of 48 percent per annum from 1992 to 1996. with a narrow exporting industry base. Net investment inflows were $3.5. an overexpansion of capacities. their growth gathering momentum only beginning in 1992. the growth in foreign investments fueled that of the manufacturing and services sectors in the years preceding the crisis. II 3. Garments was the second largest export sector at about 9 percent. Compared to other East Asian crisis-affected countries. The structure of the economy may be understood by looking at its sectoral composition and export competitiveness. The country experienced balance of payments surpluses but these were due to transfers. and agriculture at 21 percent. Net trades in goods and services averaged a deficit of 4. Because of limited local capital. but its share had been declining by 4 percent per year since 1995. After a .5 3.210 Corporate Governance and Finance in East Asia. notably remittances of overseas workers. The export sector had a very narrow breadth. the country was less dependent on foreign private capital. and intermediate goods.8 percent of GDP from 1995 to 1997. In 1997. the country’s GDP growth pace indicated that it did not have a “bubble economy. industry at 34 percent. In sum. Commercial and industrial activities in the country were largely oriented to domestic markets. 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. Vol. Exports were growing at about 20 percent per year in the three 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.” that is. foreign investments in the country have been low. with commodities accounting for the balance.5 percent per year from 1992 to 1997. Manufactures accounted for about 85 percent of exports.

The Central Bank conserved international reserves by allowing the local currency to float within a wider trading margin. shows that investments of the corporate sector were growing at a faster rate than sales revenues in the years immediately preceding the crisis. From 1993 to 1997. Five years of stable growth before the crisis enabled the country to build its net international reserves to $10.8 percent. average ROE was 13. .1 percent. The corporate sector was in a relatively stable financial condition around the time of 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. an average inflation rate of 7. In the Philippines. 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. depended on the quality of the corporate sector’s investments. The lessons from debt restructuring became the basis for the Government’s economic policies. Total debts were only 52 percent of assets or 108 percent of equity. however. Since the regional financial crisis was triggered by the loss of confidence in some East Asian economies by foreign creditors and investors.5 percent. During this time. assets grew at a compound annual rate of about 31 percent. which. Prudent fiscal management and controls on foreign borrowings were part of the adjustments required by IMF and foreign creditors. an average Treasury bill rate of 13. unlike their counterparts in the region. the Government restructured its debts into longer tenors with a maximum of 25 years. Financial institutions called on their shortterm loans and shortened the maturity of existing loans. a positive balance of payments from 1992 to 1996. and a relatively healthy banking system. Closer analysis. fueled also by successful IPOs during the stock market boom of 1993-1996.Chapter 3: Philippines 211 long period of debt moratorium and restructuring that started in 1983 and ended in 1991.6 billion as of March 1997.3 percent. a government fiscal surplus from 1994 to 1997. resulting in stability in the short-term debt to reserves ratio. the country and the corporate sector had no access to foreign currency debts from the international financial market. the ratio of short-term debts to international reserves dipped below 100 percent beginning June 1998. After hovering in the range of 100 to 127 percent. Economic performance during 1992-1997 was characterized by an average growth rate of real gross national product (GNP) at 3. Eventually. From 1988 to 1996. adjustments were focused on the quantity and quality of the banking system’s corporate loans. while sales grew by only 20 percent per year. the Government sought stability and achieved this in 19921997. in turn. Profitable operations since 1992 had allowed it to build equity.

But portfolio investment amounting to $406 million flew out of the Philippines. precisely. Sources: Bangko Sentral ng Pilipinas and SEC.300 1. These patterns in investment and financing are similar to those of other countries in the region.0 1998 739 555 328 69.4 1997 762 1. II The corporate sector indeed overexpanded after 1993 like its counterparts in the region. Net foreign portfolio investment amounted to $1. It financed 26 percent of corporate capital growth. net FDI remained stable at more than $1 billion. 1996 = 26. It rose to $2.06. the country’s economic and corporate sector growth in 1994 to 1997 appeared to have been part of a positive “contagion” effect of optimism by investors and creditors about the region.71. It is understandable then that the effect of the Asian financial crisis on the Philippines was correspondingly that of a negative “contagion. Table 3.2 Impact of the Crisis on the Corporate Sector Aside from the foreign exchange adjustment. 1995-1998 Item Net Foreign Investments ($ 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 1.22. mitigated the effects of the pullout and liquidation of investments in the aftermath. Most of this leverage happened during the boom years in the region. In sum. 1997 = 29. The debt level of the Philippine corporate sector in 1997 was low by Asian standards but still high by developed country standards.749 26.” 3.074 2.22 Foreign Investment Flows. or 114 percent of net foreign direct investment (FDI).5 billion in 1995.22).650 32.5.073 (406) 121.101 92.303 23. Net foreign investments more than doubled from 1995 to 1996 but declined by 78 percent in 1997 (Table 3. Data for 1998 cover only January-August.7 Note: Peso-dollar exchange rates used are: 1995 = 25. .101 billion or 196 percent of net FDI in 1996. Debts financed a large part of this expansion. growing by about 34 percent per year from 1994 to 1997. In 1997.517 1. but to a lesser degree.47. 1998 = 41. Vol.609 1. the other immediate impact of the crisis was that on foreign investment flows.0 1996 3. Foreign investments in the Philippines have not been as high as the inflows to other Asian countries—and this.718 30.485 145.212 Corporate Governance and Finance in East Asia.

2 percent was barely above inflation rate. A number of small banks closed but they represented less than 1 percent of the financial system’s total resources. albeit at current market interest rates.369 billion.513 billion. and leverage increased to 149 percent compared with 109 percent in 1996. Loan calls. By October 1998.Chapter 3: Philippines 213 Corporate financial performances and conditions deteriorated during 1997. Manufacturing reduced its loans outstanding by 11 percent from October 1997 levels. Although corporate borrowers were not highly leveraged. the corporate sector became vulnerable to loan calls and high interest rates. Bank loan pricing was based on the bellwether 91-day Treasury bill rates rather than inflation. The resources of the financial system that year totaled P3.2 percent in November 1997. By March 1988. When the Treasury bill rates eased in March 1998.9 percent. The combined effects of shrinking demand and high interest rates reduced the corporate sector’s demand for loans. Net profit margins were at a 10-year low at 4. then rose to a high of 22. and the wholesale and . in turn. the sectors with the highest outstanding loans had reduced their credit exposures. lending rates also came down.2 to 28. Bank spreads over Treasury bill rates increased in 1997 but were within the range experienced in the past. they could not initiate a large reduction of their loans because these in part financed long-term growth in assets. Lending rates were well above the 20 percent level from July 1997 to March 1998. Companies deferred investments in new fixed assets. suggesting that commercial banks required a higher premium at about the height of the crisis but not beyond. new borrowings financed asset growth. ranged from 11 to 13 percent from 1993 to July 1997. With the increase in borrowings and reduced liquidity. The real problem of the corporate sector during the crisis was the rise in interest rates. ROE at 6. the commercial banking sector’s capital remained strong at 17. sparking a rise in interest rates on corporate loans. The interest rates on Treasury bills. depended on the liquidity and capital position of commercial banks. The banking system was able to absorb the impact of the crisis primarily because of its strong capital position.3 percent of assets. they were willing to restructure and renegotiate existing loans by corporate borrowers. Average bank lending rates climbed to their peak of 25. which held about 75 percent of the assets of the financial system in 1997. Loans outstanding of commercial banks declined by the first quarter of 1998. Because commercial banks were strongly capitalized. in varying degrees for each sector. Because of weak internal fund generation. with commercial banks holding P2.7 percent in January 1998. meanwhile.

the ratio increased to a high of 11. These figures show that adjustment problems were industry-specific and that the real estate industry. and set up a hedging facility for borrowers with foreign currency-denominated loans. In March 1997. by 12 percent. But the Philippine banking system had gone through worse crises in the past. Still. including (i) a regulatory limit of 20 percent on banks’ loans to the . as with its counterparts in other Asian countries. the fiscal position. real estate loans averaged 11. set limits on overbought/oversold foreign exchange positions of banks.3 Responses to the Crisis Government Responses The Government’s policy and regulatory responses to the crisis focused on monetary and credit issues. single-digit NPL ratios began only since 1989. 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. This allowed the Central Bank to convince the banks.5. The move retained the liquidity position of banks but lowered their cost of reserves. The Central Bank introduced regulations on foreign exchange trading to control speculation and nondeliverable forward contracts. thereby reducing overall intermediation costs.9 percent of bank loan portfolios. However.5 percent by September 1998. was a problem sector. The pattern indicates that real estate loans were of substandard quality but banks had contained the problem by mid-1998.6 percent in June 1998. As for nonperforming loans (NPLs). to reduce their lending spreads over the 91-day Treasury bill rates from 3-8 percent to 1. 3. II retail trade sector. The Central Bank adopted other measures to strengthen the financial system. 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. and subsequently went down to 13.3 percent in December 1997. and its experience of low. Vol.214 Corporate Governance and Finance in East Asia. loans outstanding of the real estate sector increased by 11 percent from June 1997 to June 1998.5-6 percent. The latter measure was especially beneficial to companies with unhedged foreign currency loans from commercial banks. These peaked at 14. through the Bankers’ Association of the Philippines. This “voluntary agreement” partly explains why the loan spreads of banks were within the range of recent experience.

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

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

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

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

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

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

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

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

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

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

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

Private Benefits from Control of Public Corporations. Harold. Simeon Djankov. Philippine Macroeconomic Prospects: The Next Ten Years. Working Paper. Dennis Gromb. Stijn. World Bank. Monitoring and the Value of the Firm. Lang. 1999. Conference on Thailand’s Dynamic Economic Recovery and Competitiveness. Manila: Asian Development Bank. 1998b. 1985. 1994. Burkart. Barclay. 1998a. Denis. and Kenneth Lehn. Alba. Claessens. and Larry H. World Bank. July. P. Lang. II References Abonyi. and Larry H. Fan. Stijn. George. 1998c. 1999. edited by Toida Mitusuru and Daisuke Hiratsuka. Institute of Southeast Asian Studies. Who Owns and Controls East Asian Corporations? Discussion Paper 2054. Diane K. Asian Development Bank. P. 1997. Journal of Finance 2 (1). Lang. Michael. Ownership Structure and Corporate Performance in East Asia. World Bank. Lang. P. Quarterly Journal of Economics.. H. 1998. Discussion Paper. and Larry H. Claessens. Asian Industrializing Region in 2005. The Philippines: Onward to Recovery. Simeon Djankov. Expropriation of Minority Shareholders in East Asia. Claessens.. 1998. Fan. Joseph Fan. and Larry H. 1997.226 Corporate Governance and Finance in East Asia. Working Paper. Emilio. and Simeon Djankov. Journal of Financial Economics 25: 371-395. Large Shareholders. Stijn. XXIX. and Fausto Panunzi. Equity Ownership. Vol. May. 1988. Dennis. March. Simeon Djankov. Antonio. The Separation of Ownership and Control in East Asian Corporations. Bangko Sentral ng Pilipinas. and Atulya Sarin. Joseph P. Tokyo: Institute of Developing Economies. 1999. and Larry H. Thailand’s Corporate Financing and Governance Structures: Impact on Firms’ Competitiveness. and Corporate Diversification. 693-728. October. H. Diversification and Efficiency of Investment by East Asian Corporations. Fan. Claessens. Stijn. and Clifford Holderness. Simeon Djankov. Thailand: From Financial Crisis to Economic Renewal. Journal of Political Economy 93 (6). Joseph P. P. 1989. The Structure of Corporate Ownership: Causes and Consequences. Vol. Working Paper 2088. World Bank. David J. Pedro. Claessens. Demsetz. Simeon Djankov. H. Agency Problems. Stijn Claessens. World Bank. P. Joseph P. Lang. Key Indicators of Developing Asian and Pacific Countries 1998. Stijn. . Jr. M.

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

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

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

and a family-based corporate ownership structure. focusing mainly on the companies listed in the Stock Exchange of Thailand (SET). II There is now a consensus that weak governance was partly responsible for the corporate sector’s poor financing and investment practices. Key factors that led to weak corporate governance include the ineffectiveness of the regulatory framework. lack of transparency and adequate disclosure. The First and Second Plans (1961-1971) Under the first two plans. The country initiated national economic development planning in 1961 when the economy was growing rapidly. The study then considers policy recommendations with emphasis on corporate governance improvement. Vol. its growth and financial performance. To protect domestic industries.2 4. while new industries were encouraged to reduce the need for imports. Section 4.4 provides an overview of Thailand’s financial markets and examines patterns of corporate financing and investment in the years prior to the 1997 crisis.230 Corporate Governance and Finance in East Asia.2 discusses the development of the Thai corporate sector under the National Economic and Social Development Plans. Import tariffs on machinery and heavy equipment were removed. 4.2. Section 4. with government policy providing support but avoiding direct interference. the Government increased tariffs on products that could be produced locally. . The National Economic and Social Development Board was created to plan the country’s economic and social development. Section 4. Section 4.5 discusses how the corporate sector contributed to the financial crisis and looks at its impacts. the Government implemented major infrastructure projects and modified its tax policy to encourage capital investment and savings. This study examines these and other factors that might have weakened corporate sector governance in Thailand. as well as its legal and regulatory framework.1 Overview of the Corporate Sector Historical Development The corporate sector has long been considered the engine of Thailand’s economic growth.3 looks at corporate ownership patterns that resulted in inadequate protection for minority shareholders and weak corporate governance in Thailand.

lower than anticipated due to a worldwide economic recession. At the same time.Chapter 4: Thailand 231 During this period. using tax policy to control prices of consumer goods and implementing several price control measures to curb inflation. remaining high until 1981. the value of the baht remained stable. the current account registered a surplus in 1986. an improved trade balance. it proceeded with its development plan for the industrial sector. However. Thus. Fourth. especially foreign aid from the United States. Average growth for the period was 4 percent per year. helped offset these deficits.6 percent per year. But the sustained importation of heavy machinery and equipment resulted in large trade deficits. leaving the Government no choice but to resort to overseas borrowings. To close the fiscal gap. with the devaluation of the baht in 1984 a major step in this direction. In the wake of lower world oil prices and the rapid growth in income from the tourism and travel industry. however. Budget deficits also increased throughout the Fourth Plan. Consequently.4 percent of GDP.3 percent in 1974. averaging 1. however. gross national product grew by about 7 percent per year. the government’s debt burden escalated. and reduced current account deficits. including a weakening of the dollar. processed steel. capital inflows. As a result. The Third. The Government had to shift emphasis to restoration of economic stability.15 billion per year or 4. became a major problem as domestic investment declined. and automobile assembly) emerged.4 billion from overseas and increased taxes on numerous items. Industrial sector growth was also rapid and many industries (tires. with the agricultural sector the major contributor. chemicals. the Government borrowed $6. Inflation levels were low. The decline in imports was steady. External factors. the industrial sector grew at a faster rate than the agricultural sector. and increases in world food and oil prices. including luxury goods. The results were increased exports. Unemployment. The Government decided to embark on restructuring measures in the Fifth Plan (1982-1986) to rehabilitate the ailing economy.5 percent in 1973 and 24. Budget deficits remained a major problem during the Fifth Plan. Inflation reached 15. and Fifth Plans (1972-1986) An economic downturn at the end of the Second Plan led to an adjustment in policies. . textiles. The average budget deficit reached an all-time high of $2. canned foods. The focus shifted to export promotion. resulted in increases in the current account deficit.

Growth of exports and imports averaged 14. the bulk of domestic investments went to speculative ventures such as real estate. United States. property development. Singapore. an oversupply of housing emerged. Thailand’s rapid growth up to the mid-1990s made the country one of the world’s fastest-growing economies.8 percent. From 1989. II The Sixth Plan (1987-1991) Industrial sector productivity improved gradually during the Sixth Plan period.2 and 13. Growth rates during 1987-1991 ranged from 9. while exports expanded considerably. By 1995.6 percent target of the Seventh Plan. On top of its predominantly “borrowed” nature. combined with its liberal financial policies. . With loans increasingly becoming expensive and hard to come by due to a lending squeeze by the central bank and high interest rates. Average annual growth in real GDP was 8 percent. respectively. Key to this growth performance was the government’s adoption in 1993 of an aggressive program for attracting foreign capital to finance domestic investments. compared with the 8.232 Corporate Governance and Finance in East Asia. The manufacturing sector became a dominant force in the economy. Most of the FDIs—originating mainly from Japan.2 percent target. and Hong Kong. and the stock market. lower than the target of 8. The country also attracted a large amount of foreign direct investments (FDIs). reaching an annual inflow of $2 billion in 1991. compared with the 14. The Seventh Plan (1992-1996) The economy’s performance from 1992 to 1996 generally met the targets of the Seventh Plan. increasing its share in total export value from 42 to 76 percent. Inflation was 4. the Government successfully balanced the budget and even settled its foreign debt of $4 billion before this was due.7 and 11. averaging 10.4 percent targets.6 percent. Thailand became a debtor’s market. The exchange rate was steady at around B25 to the dollar. Private sector investment grew at an average annual rate of 7 percent.5 percent.5 to 13. rather than to productive activities. better than the 5. from only $31 billion in 1992. Europe. Vol.2 percent per year.8 percent. with private foreign debt reaching $92 billion by the end of 1996. China—went to export-oriented manufacturing industries. the property sector began to collapse in 1996. The country’s high ratings in the international capital market. invited a deluge of capital seeking profitable investments. compounded by a slump in property sales.

the establishment of the Securities Exchange of Thailand (SET) was legislated and trading began on 30 April 1975. However. the Government passed the Public Limited Company Act. many companies considered the Act too restrictive and a hindrance to growth. And because the Government considered the banking system vital to the development of the economy. Before the capital market emerged.” which later became the master plan for the development of the Thai capital market. Foreign banks were barred from competing directly with domestic banks. Robbins recommended an overhaul of the existing informal stock market established earlier by a group of local brokers in favor of a centrally regulated institution. on account of an overvalued baht that weakened export competitiveness. In 1972. which was amended in 1979 and 1985. with growth shrinking from 23. Sidney M. In 1978. In 1969. Under the 1962 Commercial Banking Act. placing all publicly listed companies under regulation. 4.8 percent in 1995 to 1. In May 1974.Chapter 4: Thailand 233 Toward the end of the Plan period.3 percent in 1996. a former Chief Economist from the US Securities and Exchange Commission. prepared a comprehensive report entitled “A Capital Market in Thailand. Its most crucial role was to help mobilize funds to support Thailand’s industrialization and economic development.” extending its control and regulatory powers to the finance and securities companies operating freely at the time. the corporate sector’s main source of funding was the banks. The country had a current account deficit of about 8 percent of GDP in 1995 and 1996. the capital markets didn’t play a significant role until 1975. In his report. a policy that held throughout the first six economic development plans. Exports went into a tailspin. The deficits caused the Government to rely on even more external borrowing. 58 on the Control of Commercial Undertakings Affecting Public Safety and Welfare.2.2 Development of Capital Markets Although the corporate sector has long been the government’s main tool for economic development. which raised the debt service ratio. its policy had always been to protect domestic banks. the Bank of Thailand and . the Government amended the “Announcement of the Executive Council No. A series of increases in customs and excise taxes on luxury imports did little to stem rampant consumer spending. Included in the Second Plan (1967-1971) was a proposal to establish the country’s first authorized and regulated securities market. SET officially became “the Stock Exchange of Thailand” in 1991. Robbins. the signs of an economy about to falter were there.

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

and Water Construction Wholesale and Retail Trade.1 78.0 19.5 791. The manufacturing sector is a far second with registered capital of B350 billion and paid-up capital of Table 4. about 661 companies with total registered capital of B2.9 16. 1978-2000 Number Registered of Capital Companies (B billion) 5 6 245 5 13 129 22 194 42 661 1.6 23. the financial sector is the largest.3 Growth and Financial Performance Since the 1978 enactment of the Public Limited Company Act. Social and Personal Service Total Note: The data for 2000 is as of October 2000.Chapter 4: Thailand 235 fast-growing neighbors. however. The result was a corresponding growth and development in Thailand’s capital markets.9 261.0 110. finance.3 trillion have been registered with the authority (Table 4. Forestry. and Restaurants and Hotel Transport. Financial deregulation and liberalization were key to realizing that vision.0 Paid-up Capital (B billion) 1. with B1. 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. and Communication Financing.6 2.9 34. The majority of the companies are in manufacturing.4 trillion in registered capital and B791 billion in paid-up capital. The stock market boom from 1991 until the financial crash of 1997 reflected international investors’ response to Government policies. Thailand. .9 1.2 Type of Business Agriculture.1 Public Companies Registered.2. Storage.101.5 50. and wholesale/ retail trade and restaurant/hotel sectors. Hunting.394.1 trillion and paid-up capital of B1.0 21. In terms of capital.1 30.291. Gas. Ministry of Commerce. in that order.6 1. 4.2 11. and Fishing Mining and Quarrying Manufacturing Electricity.5 111. Real Estate.1). Insurance.6 350.3 83. and Business Service Community. the country became recognized as an economic development model for other emerging economies. Worldwide.

1 286.2 5.0 0.8 — 26.7 billion and B27.6 7. While a rebound was apparent beginning in 1998.2 Public Offerings of Securities. 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 1.4 34. reached . respectively.3 31.4 277. The development of the corporate sector closely followed the development of capital markets. moreover.4 96. the year before the crisis struck.5 39.7 5. this was due to the recapitalization of commercial banks in compliance with the new loan provisioning requirement.6 39.236 Corporate Governance and Finance in East Asia. allowed Thai financial institutions and corporations to obtain funds overseas.7 billion in 1996. The signing of Article VIII with the IMF.7 7.3 6.3 194. from only B20.3 22.7 9. reducing the value of offerings to a little more than a quarter of the previous year’s level. Domestic and offshore debt issues reached B54.0 20. Table 4.1 — — — 6. the capital market became instrumental in the rapid growth and development of the corporate sector.7 136. After the passage of the SEA of 1992.3 1996 1997 65.5 — — 56.3). Market capitalization.8 151. The preeminence of the financial sector is a direct result of financial deregulation and liberalization.8 billion.2). Securities and Exchange Commission of Thailand. With the enactment of the SEA of 1992 that brought suppliers of finance services and their clients together.9 31.2 25.5 1.1 2. These peaked at B89.1 54. reaching a precrisis peak in 1996 (Table 4. The number of listed companies and securities steadily increased until 1996 (Table 4. The 1997 crisis battered the primary market for securities.6 8. II B261 billion.7 27.4 51.6 174. Debt market activities also increased significantly with the establishment of the Bond Dealers’ Club (BDC) in 1994.5 1.2 12. the value of public offerings rose steadily.6 — = not available.0 1994 82.1 599. Source: Key Capital Market Statistics.8 1995 64. The stock market also became an invaluable source of funds for corporations.2 40. Vol.9 37.9 1998 1999 15.8 201.5 billion and B1 billion the previous year. meanwhile.

While the decline in gross profit margin was not as sharp. when long-term debt grew as Thai corporations began to borrow heavily to finance growth. ROA dipped from 10.4).193 2. had been on the rise throughout the 1980s.114 1.565 2.535 1.Chapter 4: Thailand 237 Table 4. was the ominous deterioration in the key financial ratios of publicly listed companies. the companies could not generate enough net returns from their assets and equity.360 1. however. the highly liquid financial system continued offering cheap funds to sustain corporate sector investments. pulled down by active public offering activities. 1993-1999 Item Number of Listed Companies Number of Listed Securities Market Capitalization (B billion) Turnover Value (B billion) SET Index a 1993 1994 1995 1996 1997 1998 1999 a 347 408 389 494 416 538 454 579 431 529 418 494 392 450 3. the average times interest earned (TIE) was down to 5.301 3. The upward trends for ROE and ROA continued through 1989.133 1. however. The key financial ratios of all companies listed on SET bear this out (Table 4.3 Statistical Highlights of the Stock Exchange of Thailand. The trend reversed in 1995.201 2. Source: Securities and Exchange Commission of Thailand.610 1. Side by side with this surge of financing for corporate growth. then stalled in 1990.1 by 1996.303 930 855 1. the averages for all three profitability ratios took a downswing all the way until 1996. and gross profit margin.268 2. their share rising from 17 percent in 1993 to 43 percent in 1997. From 10.5 at its peak in 1987. resulting in their inability to fulfill debt obligations.6 trillion.683 1.325 3.560 1. By the early 1990s. not all public companies are listed on the SET. ROE similarly fell from 21. in the end. gross profit margin rose until 1991 before falling in 1992. Meanwhile.4 percent in 1996. Throughout the 1990s.4 percent to 5.3 percent in 1989 to 3. return on equity (ROE). Foreigners accounted for an increasing proportion of SET’s turnover value. But instead of shifting to a low gear.8 percent. The financial leverage of all companies declined until 1994. as measured by return on assets (ROA).281 832 373 356 482 Due to listing requirements and other reasons. corporate profitability had been declining. Corporate profitability. The plunge in profitability and asset turnover—from 117 percent in 1985 to 65 percent in 1996 for the latter—cast doubts on the . its high point in 1995 at B3.

7 4.0 145.1 9.2 10.4 7. the textiles.7 34.1 60.0 117.1 16.0 139. resulting in higher collateral values for borrowers.9 14.8 8. practice of heavy borrowing.9 7.8 5.0 63.3 12.1 120.8 151.4 12.9 66.9 140.8 88. these companies opted for debt. Vol.7 LongTerm Debt to Asset Assets Turnover (%) (%) 14.9 77.4 4.2 215. US.7 35.7 12.2 27.4 5.7 27. Korea and Thailand had the highest debt-to-equity ratios.6 168. Despite the availability of the equity market.7 27.4 18.7 12.4 26.7 21.4 51. They were generally more efficient in managing their assets and .4 3. A major reason for this was the rapid rise in asset prices.8 25.6 27. was felt across industries.4 24.5 63. and footwear industries also experienced losses.0 125.2 10. II Table 4. but was most severe in building and furnishing material industries as a result of the downturn in the real estate market.2 27.6 12.8 5.4 7.3 4. Thailand’s ROE.238 Corporate Governance and Finance in East Asia.7 54.3 10.0 29.7 59.2 35.4 Key Financial Ratios of Publicly Listed Companies.1 44.0 3.9 51.7 15.5 15. clothing.1 16. 1985-1996 LongTotal Term Total Return Return Gross Debt Debt Debt on on Profit Times to to to Assets Equity Margin Interest Equity Equity Assets (%) (%) (%) Earned (%) (%) (%) 3.2 10. clothing.9 7.9 8.1 114.3 8.0 7.6 36.7 12.7 12.7 5.5).6 7. Severely affected by global competition throughout the decade.7 5.5 9.5 30.6 Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.4 12.2 6.1 242.2 49.2 64. and footwear had the lowest at 11 percent. Among the crisis-hit countries.5 52. was also distinct in the region. Overall. Hotels and travel showed the highest ROE of 15 percent while textiles.9 27.4 47. It has also been argued that family-based controlling shareholders borrowed excessively to avoid diluting their control over their corporations.1 52. large companies (where size is reckoned in terms of assets or sales) were more profitable than small companies in terms of ROE (Table 4.5 50.6 138.6 125. The downtrend in corporate profitability.9 144.4 44.7 5.4 119.8 54.3 91.8 14.8 51.2 161.9 39.8 11. which fell from 16 percent in 1991 to just under 6 percent in 1996.4 139.4 34.6 41.4 9.7 80.5 38.7 20.4 28.5 51. which was particularly significant in the two years preceding the crisis.

8 10.4 8.6 12.3 176.4 52.1 13.5 94.6 31. it was thought.3 52.8 6.3 49.7 10. US.8 47.6 5.Chapter 4: Thailand 239 Table 4.5 6.4 116.1 5. The argument was that having a Board of Directors whose members represented different groups of investors would create conflicts and hamper management effectiveness. Although stable in the 1980s.1 Small Medium Large 5.7 14. by the 1990s.6 61.3 49.3 164. 4. In sum.7 6. although the performance of listed companies in the late 1980s was strong.6 7. weaknesses became evident. some rules and regulations of this particular law were believed to be too restrictive and were discouraging companies from going public.2 134. the overall activities of listed companies. . They also tended to use more financial leverage than small companies as their total DERs show.8 6.6 30. For instance.3 15. which would be disruptive to company management.5 Average Key Financial Ratios by Company Size.2 18.1 6.0 20.0 48.0 83.9 13.3 43.1 29. Increasingly heavy borrowings rendered the sector even more vulnerable to lower profitability and sales. There were also concerns that the provisions governing the criminal prosecution and penalties of directors and management were harsh and inappropriate.5 87. total asset turnover declined after 1989. Cumulative voting.2.3 88.2 10. the Public Limited Company Act of 1978 and its amendments regulated Thai publicly listed companies.6 10.1 25.8 142. 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 6.8 26. also deteriorated.6 30.8 62. could lead to a high turnover in the board. However. During the 1990s. capital despite the higher gross margins of small companies.4 Legal and Regulatory Framework Before 1992. the law disallowed cumulative voting.9 20.6 6.7 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.2 121.3 135.3 23. measured by total asset turnover.2 12.3 25.5 7.

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

2 4.4 4.Chapter 4: Thailand 241 4.6 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand.4 26.9 3.9 6. Source: Comprehensive Listed Company Information Database. this was not the case. .7 12.9 11. one would expect the public.1 3.4 26.7 7.4 10. 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.0 3.1 5. 56.4 6.0 3. 33.9 4.4 percent of outstanding shares.9 percent of shares of a company.2 4.5 Average for 1990-1998 period.1 7.0 7.3 7. these companies obtained funding solely from banks or from their own retained earnings.2 4. In the past. In contrast.3 28.2 11. the top five shareholders of each of publicly listed Thai companies held.3 7. creditors.9 26.0 7.1 12. This implies that the top five shareholders enjoyed full control over the outcomes of shareholder meetings. and Hong Kong.7 6. and minority shareholders to stake their claim in the control and regulation of these companies.9 3. respectively. and 28. Ownership Concentration Between 1990 and 1998. Table 4.6 4.5 9.4 5.8 32.9 52.3. on average.5 28.3 percent.2 56.3 16.9 52. Most large Thai corporations listed on SET started out as family businesses.3 5.0 53.8 11.1 4.6 57. with the top three shareholders accounting for almost 50 percent (Table 4.1 percent of control rights.8 5. 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. Stock Exchange of Thailand.6 68.6 28.7 11. Unfortunately.1 Patterns of Corporate Ownership A World Bank study covering nine Asian countries finds that firms in Japan and Taipei. with the largest shareholder on average controlling 10.1 11.3 11.0 56.4 6.0 5. Indonesian.1 5.6 27. there were only slight variations in the pattern.9 52.9 55.7 percent.China have the least concentrated ownership. But with their increased reliance on new varieties of equity and debt instruments. Thai.6).1 5. Across industries.3 percent and 18.9 54. China firms have the highest single shareholder ownership concentration at 35.4 26. Ownership was most concentrated in the packaging.

080 6. founding families maintain effective control of entire groups. year. US.7 percent of outstanding shares on average (Table 4.7 Statistical Relationships between Corporate Profitability. On the other hand. Table 4.647 Note: The regression included dummy variables for industry. Ownership Concentration. and building and furnishing industries. II agribusiness. and Company Size Item Intercept Top Five Ownership Concentration Company Size Adjusted R-Squared F-Statistic ROA 0. Composition of Controlling Shareholders Affiliated corporations comprise the largest group among the top five shareholders of publicly listed companies.115 9.001) 0. Other industries had their top five shareholders controlling at least 55 percent of outstanding shares.116) Debt-to-Equity (1. Source: Author’s estimation based on the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.169*** 0.058* ROE (0. Based on a regression analysis.029 3.001*** 0.037 0.800 0.001 0.005** 0.242 Corporate Governance and Finance in East Asia. owning 26. including those that are publicly listed .8).7). Company size is significantly related to ROE and leverage. and ownership types. * Denotes significance at the 10 percent level. Leverage. *** at the 1 percent level. 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 4.003 0. with a top-five ownership concentration of at least 60 percent.034*** 0.090 0. It is the practice of Thai corporate founding families to set up holding companies to own shares in affiliated companies or subsidiaries. results show a significant positive relationship between ownership concentration and financial leverage. as measured by debt-to-equity and debt-to-asset ratios.022*** 0.072) (0.031 3.533)*** Debt-to-Assets (0. Through these holding companies. 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. ** at the 5 percent level. Vol.

5 1.6 1.3 percent of outstanding shares. one of the founding members.5 5. a company listed in the real estate sector of SET.8 1. owned by the Chirathivat family.3 1. the affiliate firms rarely hold shares of their parent companies.6 28.6 5. This practice is illustrated by Central Pattana. 1990-1998 Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 Average Company 28.0 19.2 5.2 1.5 26.Chapter 4: Thailand 243 Table 4.5 0.0 18. the company increased its registered capital and became a public company listed in SET.4 1. unlike in Japan where crossshareholding is common.8 23.9 19.4 1.5 Individuals 13.5 0.3 20.5 0.3 27.4 20.2 18. operates five of the most successful shopping malls in Thailand.3 1.9 15. individual members of the Chirathivat family aggregately hold 25. with 29.7 5.8 Top-Five Shareholder Composition of Publicly Listed Companies in Thailand. Typically. Source: Comprehensive Listed Company Information Database.9 6.1 0. in SET.9 0.8 28.0 17.4 1.3 — = not available. Although holding companies set up affiliate firms. Stock Exchange of Thailand. averaging about 18. In addition.5 NBFIsa 6.2 7.5 1.6 1. the company.7 0.7 1.9 7.3 27. including finance and investment companies.5 percent.1 1.0 3. Individual family members also hold a significant amount of outstanding shares.5 2. Established in 1980 with a registered capital of B300 million.9 18.4 22.2 1. The largest shareholder is Central Holdings Company.7 Bank 2. These individuals usually hold important management positions in concerned companies.3 0.1 4. a joint venture among three families.8 0.6 1.7 — 1.5 Government Other 0.1 1. The roster of its major shareholders as of December 1997 illustrates the typical ownership concentration of a publicly listed company in Thailand. The top 10 shareholders include a holding company owned by the Tejapaibul family. . founding families and their relatives maintain control of many companies by jointly holding on to the most significant chunk of shares.3 27.6 25.6 percent of outstanding shares. In 1994. a NBFIs denotes nonbank financial institutions.3 1. The ADB survey indicated that listed companies held shares in an average of 11 companies.

. For example. In effect.3. they account for 80 percent of total outstanding shares. There was a trend of rising government shareholdings throughout the period 1990 to 1998.2 Corporate Management and Control3 Board of Directors The Public Company Act of 1992 stipulates the appointment process. Nonbank financial institutions hold an aggregate 5. Although the list of top shareholders of publicly listed companies includes financial institutions. the top 10 shareholders consist predominantly of members of founding families and their holding companies. Except in the hotel and travel service sector. these shareholders are able to control the company. Vol. 1. qualification. Only a handful of companies have the Government among their large shareholders. II another of the company’s founding members. and responsibilities of directors of public companies. 4. the Government’s role in public companies is expected to decline. roles.5 percent of total outstanding shares. In such cases. Together. However. 3 Discussions in this section are based on results of company surveys by SET and ADB.9 percent of outstanding shares. Thai Airways International Plc. they exercise limited influence in operations because of the restricted size of their shareholdings. Another example is Bangchak Petroleum Plc. . with the envisioned privatization master plan. both conducted in 1999. By owning 62 percent of voting shares. Across industries.5 percent of total outstanding shares of listed companies. where the top three shareholders are the Ministry of Finance.1 percent of total outstanding shares of listed companies. the predominance of individual family members and holding companies in the top shareholder list remains valid. About half of listed companies have nonbank financial institutions such as finance and investment companies in their top-five shareholder list. On average. Moreover.244 Corporate Governance and Finance in East Asia. the Petroleum Authority of Thailand. commercial banks account for only 1. and a state bank. holdings by individual family members and holding companies account for at least 50 percent of outstanding shares of an average listed company. on average. only one tenth of listed companies have commercial banks on their top-five shareholder list. duties. the Government owns the majority of the shares. has the Ministry of Finance as its only large shareholder with 92. The Government holds.

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

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

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

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

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

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

Even when companies offer ESOPs. . employees are even less willing to accept common shares as a form of compensation or benefit.Chapter 4: Thailand 251 Table 4. The number of domestic institutional investors rose after the mutual fund industry was established in 1991. but the average shareholding is smaller than 1 percent of total outstanding shares. not with a view to becoming involved in actual management. Eleven of the 46 responding companies in the ADB survey offer ESOPs. 1993-1999 Year 1993 1994 1995 1996 1997 1998 1999 a Tender Offer Valuea (B billion) 5. But instead of opting for an active role in the market for corporate control.1 58. it remains small. but employees have never been represented in the board of directors since their shareholdings are minimal. Provident funds for government workers and workers in public enterprises have been established only recently.2 6. Since 1994. Source: Securities and Exchange Commission of Thailand.1 84.5 6. if any.2 7.3 6.3 60. tion activities increased after 1997. they have mostly been concerned with short-term gains.0 55.7 Purchase Value Number of % of Tender Offer Value Companies 84. employee participation in corporate governance in Thailand. employees regard the plans as monetary incentives.6 17.7 11.8 81. Employee Participation in Corporate Governance There has been little. Twenty-nine firms indicated that employees held shares of their companies.2 8. Few companies offer employee stock option plans (ESOPs). While the Thai mutual fund industry compares well to those in other developing countries in the region.1 75. trading by mutual funds in SET represented less than 10 percent of total trading.2 6.8 8 27 14 6 9 13 23 Tender offer value refers to the minimum offer value. most of these were forced mergers or related to rescue packages.9 Merger and Acquisition Activities.4 23.1 19.0 B billion 4. Pension funds are perhaps even weaker in Thailand. Because of the current crisis.3 11.9 3.

912.3 1. .4 4.325.037.230. 15 of which were domestic banks. The bond market played only a marginal role in corporate financing.979. although its role increased in the wake of the crisis.1 7.6 6.825.1 6.564.430.4.559. The share of domestic banks in the banking system’s total assets was 80 percent. Thai Bond Dealing Centre.360.1 5.8 941.300.5 Outstanding Loans from Commercial Banks 2.119.0 SET Market Capitalization 1.477.5 4.10) shows that Thailand is a highly bank-dependent economy.133. and Bank of Thailand.5 5.4 1.2 2.6 1. The Banking System Until recently. The total values of loans from financial institutions and commercial banks were consistently larger than the market capitalization of SET. 1992-1999 (B billion) Outstanding Loans from All Financial Institutions 2. the next four largest banks accounted for 63 percent.5 6.906.5 4.3 5..663. II 4.0 3.2 262.775.10 Size and Composition of the Thai Financial Sector.0 8.161. Competition from foreign banks was limited as they were not allowed to engage in full branch operations.390.1 Domestic Debt Securities Outstanding 215.4 519. total assets of commercial banks amounted to B5.485. the banking sector was highly concentrated.1 3.3 546. The country’s largest bank.193.5 trillion.4 Year 1992 1993 1994 1995 1996 1997 1998 1999 Source: Stock Exchange of Thailand.8 3.4 4. there were 29 commercial banks.1 Corporate Financing Overview of the Financial Sector A breakdown of the Thai financial sector for the period 1992-1999 (Table 4.669.6 2.0 424. accounted for 28 percent of the banking sector’s total assets. Many large commercial banks had affiliates among the 93 finance companies that served the high-risk market.252 Corporate Governance and Finance in East Asia.1 3.372.171. Vol.0 339.268. Bangkok Bank Ltd.9 2.4 3. Table 4. In 1996.

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

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

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

6 — 0.0 281.4 110.1 6.7 821.1 12. Vol.3 6.8 47.1 10.5 5.1 59.5 — — — 3.9 20.0 0. However.11 Offerings of Debt Securities.4 — 26.9 37.2 57.1 8. BDC was established in November 1994 by 50 securities companies based on the provisions of the SEA of 1992.4 billion. By 1995.4 57.5 43. The following year. Total offshore debt offerings peaked in the run-up to the financial crisis.1 55.5 55.7 0.6 — — 0.4 — — — 1.1 — — 6.3 46.7 90.0 17.3 13.2 2. . this had climbed to B200.9 40.8 Source: Securities and Exchange Commission of Thailand and the Thai Bond Dealing Centre.5 — — — — 1.9 329.7 0.6 19.7 — — 40.2 28.0 27.7 538.8 191.3 140. turnover value had reached B51.5 — — 32.0 60.5 138.0 86.7 5.1 141. by the end of 1997.4 — 9.0 5.3 8.6 billion.2 39.9 5.0 — 26.0 — 5.7 28.3 — 14.1 121.1 41.2 — — 50.9 37.4 49. II Table 4.8 55.7 5.7 132.0 7.1 107.1 21.2 43.5 — 0.3 3.2 89. The domestic debt market declined after 1994 because corporations could borrow offshore at lower costs.1 289.3 29.7 7.2 45. The club was considered the first organized secondary bond market in Thailand to serve as the wholesale market for debt securities.5 37. the year the crisis unraveled and the baht was floated. total offshore debt offerings had plunged by 68 percent to a mere B28.7 95.0 26. a surge attributed to capital inflows encouraged by high returns on Thai bonds. then declined substantially in 1996 and 1997.0 — 5.4 7.0 33.256 Corporate Governance and Finance in East Asia.0 333. A sharp rise in unsecured offshore debt offerings can be noted all the way through 1996.8 2.9 30.3 46.1 315.1 61.5 10.7 — — — — — 4.8 31.5 — 39.1 — — — 29.9 0.3 22. 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 — — — — — — 400.3 50.7 — — — — — — — 77. The decline in total domestic debt offerings in 1996 can be ascribed to the increase in offshore convertible debts.5 billion.3 — — 3.8 167.

steadily easing up between 1990 and 1996.2 billion as a result of the default of debentures due to the Asian crisis. In any case. For the construction industry. The ratio of net working capital to total assets decreased from a peak of 31 percent in 1993 to 28 percent in 1996. The overall trend is consistent with the decline in profitability observed in the analysis of corporate sector performance earlier. 4. In 1997. The closure of 58 finance companies affected the BDC significantly since half of its members were suspended as a result. Retained earnings accounted for about 30 percent of total equity financing. Construction and property development industries tended to have high proportions of long-term loans and debentures. Thailand’s publicly listed companies rely mainly on loans from commercial banks and financial institutions to finance their growth. Turnover fell further to B72. There was also little change in the trend in retained earnings within the seven-year period. turnover value plummeted to B106. Equity financing remains an important part of listed companies’ long-term financing. BDC was renamed “the Thai Bond Dealing Centre” following its status upgrade to a bond exchange. Longterm loans accounted for about 20 percent of total liabilities. cash balances. while for the property development industry. these comprised 31 percent. From 1990 to 1996. with equity levels remaining high despite an increase in debt. short-term loans accounted for more than 40 percent of total liabilities. judging by their relatively low levels of retained earnings. In the same year.4. The proportion of accounts receivable also declined steadily.Chapter 4: Thailand 257 compared with investment in equities. At lower than 5 percent of total liabilities. the use of debentures remains minimal even though the trend was generally upward until the 1997 crisis. significant variations can be noted. Across industries. In addition.1 billion in 1998. a trend most apparent in the leap between 1991 and 1992.12). overall asset quality and liquidity of listed Thai companies deteriorated throughout the period. Companies in construction and property development seemed unable to generate internal funds.2 Patterns of Corporate Financing An examination of financing patterns among Thai companies listed in SET shows that on the asset side. they also had a relatively small proportion of equity and . these accounted for 33 percent of total liabilities. and marketable securities holdings. The average for all industries was only 22 percent. listed companies experienced liquidity problems with declining reserves of cash and marketable securities during the period 1990 to 1996 (Table 4.

7 52.0 6.6 12.5 0.7 16.1 13.4 6.4 7.0 100.6 8.0 100.1 49.4 8.7 17.2 42.8 9.3 14.6 38.3 6.9 14. 1990-1996 (percent) Item All Years 1990 1991 1992 1993 1994 1995 1996 2.1 7.0 100.3 21. medium.6 0.6 10.2 2.2 17. US.9 14.8 21.0 1.3 17.9 6. The level of total liabilities for the group characterized by high ownership concentration . Analysis of common-size statements by ownership concentration (based on the levels of top-five ownership concentration classified as high.9 14.9 12.0 100.0 12.6 21.2 15.9 20. Vol.1 2.4 21.7 50.0 100.9 17.2 12.6 36.2 1.6 22.12 Common-Size Statements for Companies Listed in SET.2 1. and low) also underscores that companies with high ownership concentration had high levels of long-term loans (Table 4.8 7.0 51.6 0.9 14.0 100.6 51.0 100.0 10.9 0.8 37.8 10.3 34.2 1.8 35.9 49.7 14.4 17.4 17.1 36.3 18.8 1.9 10.6 13.2 43.9 16.8 8.4 49.7 16.9 15.8 19.1 5.0 100.9 3.13).7 7.6 0.2 17.0 100.0 100.6 18.8 20.2 17.4 43.1 18.0 13.3 14.9 43.2 22.2 45.5 9.4 14.9 50.6 100.0 100.2 16.0 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.6 100.3 50.8 9.4 2.9 18.7 18.6 15.6 2.2 17.2 35.0 7.3 1.6 14.3 25.2 2.3 12.5 43.9 17.6 0. Printing and publishing companies had lower financial leverage than companies in other industries.6 50.5 1.8 3.0 100.3 38.9 14.4 48. II Table 4.8 6. The agribusiness industry relied more heavily on short-term loans at 56 percent of the industry’s total liabilities.0 14.7 15.2 2.3 2.2 3.0 15.9 38.3 1.3 34.2 43.7 0.3 49.9 6.0 100.6 6.258 Corporate Governance and Finance in East Asia. were highly leveraged.5 14.8 37.3 48.0 100.7 1.8 14.5 37.6 11.2 16.0 2.2 2.0 10.9 2.4 49.5 11.8 34.2 34.7 36.1 50. compared with the 44 percent general average.0 48.7 9.1 17.8 46.5 9.9 40.8 17.5 1.3 18.5 1.8 25.

4 49.2 8.6 2.2 14.0 Medium 2. For the high ownership concentration group.0 16.5 18.Chapter 4: Thailand 259 Table 4.9 100. US. .3 35.0 41.6 15.9 16.9 7.6 0.2 11.13 Common-Size Statements of Public Companies by Ownership Concentration.6 9. Companies with medium ownership concentration tended to have a higher proportion of short-term loans.9 2.0 Low 1.7 17.3 1.8 13.9 0.5 13.0 100.5 11.2 45.4 35. was 53 percent of total assets compared with 49.0 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.1 18.8 13.1 49.4 37.6 47.2 0.3 1.3 16.9 36.9 21.9 50.7 12.0 6.0 6.7 19.1 36.4 7.0 7.5 100.6 22.3 8. 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 2.8 12.4 13.6 100.5 21.4 18.7 percent for medium ownership concentration companies and 49. This is consistent with the observation that majority shareholders try to maintain their control by utilizing debt as a major source of funds.1 44.2 22.6 14.4 3. common equity accounted for a smaller proportion of total assets (47 percent) than companies with lower ownership concentration.0 14.5 percent for low ownership concentration companies.8 37.0 100.0 19.3 100.4 1.4 50.1 53.

260 Corporate Governance and Finance in East Asia. Generally.0 50.1 in 1996. Table 4. As a result. Public companies relied more on short-term debt financing in the period before the financial crisis. II Results from the ADB survey reveal that Thai companies preferred to use reserves and retained earnings as their first choice of financing.8 65.8 5. The financing patterns indicate that companies with high ownership concentration were more highly leveraged than companies with medium and low concentration.3 31. bond issues.7 34. it would seem that firms with concentrated ownership and associated links to the banking system have easier access to debt financing. 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 4.4 7. .4 51. thus rendering them more vulnerable.6 41. Vol.3 61. More important.8 51.8 151.8 65.7 percent in 1996. While further detailed investigations are necessary.1 31.9 63. US.1 23.1 16.1 52.7 28. was the headlong deterioration of firms’ ability to meet their interest payment obligations.9 7.1 64. Short-term debt accounted for most of the increase. these firms more easily increased their leverage.0 28. The TIE ratio declined from its peak of 7.2 49.14).9 51.7 5.5 52.0 145. After the crisis.14 Financial Ratios of All Listed Firms. minimization of transaction and interest costs.7 12.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. The ratio of total debt to total assets increased from 50.6 125.0 25.9 14. Such deterioration of financial positions during the period was a common feature of listed companies.1 144.1 16.7 12.7 66. The direct relationship between the degree of leverage and the degree of ownership concentration is apparent in Table 4.4 44. however.4 139. bond issues overtook loans from commercial banks as the second preference.1 31. especially from 1994 to 1996.9 140.1 44.4 5.4 12.2 35. followed by bank loans.6 7.7 11.2 68. and rights issues. 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 8.6 138. however.15.7 34.8 percent in 1990 to 52.5 38.7 in 1994 to 5. and maintenance of the existing ownership structure. the choice of financing is determined by the company’s liquidity considerations.

8 49. The corporate sector contributed significantly to the crisis because of its rising levels of leverage. The composition and term-structure of this debt. . Their average annual growth rate declined from 28.6 11.15 Financial Ratios of Listed Companies by Ownership Concentration.5 4. private debt accounted for 84.5 148. peaking in 1994 at 84 percent.8 66.2 124.5 34. From only 34 percent in 1986.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.8 Medium 7. 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. Additionally. 4. such as direct equity and portfolio investment.7 percent from 1991 to 1996.3 42. continued to slide from 1985 to 1997.9 percent in 1997.5 percent between 1985 and 1990 to 8.16).4 13.8 28. however.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.5.8 14.8 29.2 percent in 1986 to 251. From 45 percent of total net capital movements in 1985.1 High 6.4 27.4 percent to 46 percent during the same period. is even more telling. unhedged foreign exchange liabilities.5 126.0 64. The proportion of nondebt-creating capital flows.4 52.6 30. debt-creating capital inflows rose to 65 percent in 1990. The proportion of external debt as a percentage of GDP consequently increased from 42. This decline was accompanied.5 percent of external debt in 1996 (Table 4. by a remarkable growth in the proportion of debt-creating capital inflows in the wake of the development of the debt market and the establishment of the BIBF. Nonbank private debt increased from 27. the proportion of short-term debt increased from 15.8 percent in 1986 to 52 percent in 1995.Chapter 4: Thailand 261 Table 4. on the other hand.4 63. and a preponderance of short-term debt liabilities. US.

0 3.7 0.4 10.1 2.6 7.2 15.3 0.9 13. .9 29.0 11.8 0.1 5.5 12.0 Long-Term Short-Term BIBF Commercial Bank Long-Term Short-Term 0.6 Total 18.7 2.3 20.6 52.3 — — — — — — — 6.5 12.9 11.9 3.3 0.8 108.3 2.9 5.1 64.5 19.1 12.6 — 0.2 10.Table 4.8 3.1 95.3 0.3 37.8 13.5 14.9 100.3 0.9 10.5 1.8 10.7 1.7 109.3 0.3 0.9 43.5 4.1 22.9 1.3 105.9 35.7 24.4 5.3 3.0 11.2 14.9 31.2 32.5 4.8 3.3 12.3 0.2 0. 1986-1999 ($ billion) Private Nonbank Long-Term Short-Term 3.1 Source: Bank of Thailand.4 2.9 7.6 Government Year Long-Term Short-Term 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 12.5 16.9 3.1 0.9 1.7 23.4 — — — — — — — 1.3 16.1 30.9 10.0 6.2 2.9 6.1 34.9 6.1 23.7 13.4 15.0 0.8 12.2 2.8 31.1 0.0 13.2 2.3 3.4 3.2 0.0 4.0 8.0 21.4 18.3 10.6 18.2 0.1 0.6 1.9 0.3 0.16 External Debt.3 7.7 10.1 0.9 4.7 20.

With easy access to foreign funds. At the end of 1994. The value of public offerings sank in 1997 to B56. (ii) the rise in the nonperforming loan (NPL) ratio and consequent tightening of credit even for viable firms. 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. the SET Index stood at 1. foreign currency-denominated debts constituted 55 percent of their total debt portfolio. trading activity at SET had been on the downturn. . Even before the crisis.360. banks would be recording more of such NPLs. After that.Chapter 4: Thailand 263 This shows that although banking and finance companies suffered most because of their short-term exposure. SET’s dismal performance is indicative of the extent of the setback suffered by the Thai capital market. the numbers of bankruptcies and company closures reached all-time highs in 1998 (Table 4. leaving domestic investors with large capital losses. Aside from the problem of NPLs. Most of these foreign debts were not properly hedged. Due in part to liquidity problems on the one hand. On average. outstanding credit also declined throughout the second half of 1998. the number of newly registered companies dropped to a 10-year low in 1998. the index declined to 1. and poor business confidence on the other. NPLs spiraled from 12 percent in the second quarter of 1997 to almost 40 percent in the third quarter of 1998. based on the three-month past due definition. The severity of the impact of the crisis on the corporate sector was apparent from (i) the decline in the volume of public offerings. If lending rates remained high. Similarly.17). large Thai companies had actively borrowed at low interest rates from foreign financial institutions. The proportion of NPLs as a percentage of outstanding loans demonstrates the liquidity problem experienced by the corporate sector. suggesting that serious investors have not returned to the market. Trading volume has since been thin. reaching 45 percent of total outstanding credit in December. closures. nonfinancial companies also experienced severe liquidity problems as a result of the baht’s devaluation. Meanwhile.281 in December 1995 and to 831. Foreign investors retreated from the market. It hit a 10-year low in the second quarter of 1998. and drastic decline in the number and capital of newly registered companies. according to the Bank of Thailand. The effects of the crisis were felt across all industry sectors.6 in December 1996.6 billion from the 1996 level of B201 billion. and (iii) bankruptcies. the liquidity problems faced by the corporate sector are likely to continue for some time. exposing the companies to disaster when the baht started tumbling on 2 July 1997. from its peak in 1995.

695 3.112 9. 1985-1999 Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Newly Registered 10. the Thai Government was lukewarm to the idea of obtaining IMF assistance because of the requirements and conditions attached to the financial package.066 19.6 in 1997.677 Bankrupted/Closed 2. The first Letter of Intent was cosigned by the Minister of Finance and the Governor of the Bank of Thailand on 14 August 1997. The increase of the P/E ratio in 1998 was mostly a result of a decrease in earnings for most listed companies. Thailand. .925 12.307 4.407 28.777 11.095 14.201 24.334 4. The price-to-earnings (P/E) ratio deteriorated from 19.218 3.288 35. IMF required Thailand to meet a set of performance criteria and implement various restructuring measures. Ministry of Commerce.5. the Government was left with no choice. Vol.409 6.264 Corporate Governance and Finance in East Asia. As part of the assistance package.105 4.2 billion for balance of payments support and buildup of the country’s reserves.792 7.2 Responses to the Crisis Initially.134 31.224 4. But when assistance from other sources did not materialize. 4. It also explains the higher dividend yield ratio.096 22.17 Number of Newly Registered and Bankrupted/Closed Companies.902 3.5 at the end of 1994 to 12 in 1996 and further to 6.797 4.410 37.933 25. The IMF financial package was a credit facility of $17. II Table 4.977 Source: Department of Commercial Registration.915 37.904 20.312 25.410 5. A steady price decline over the past few years has dragged down the ratio of market price to book value.052 36.080 9.

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

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

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

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

This point is crucial because compared with . In response.767 cases involving outstanding credit of B2. Commercial banks initiated 74 percent of these cases. Cases for which negotiations were unsuccessful. Within three months.1 trillion in outstanding credit. Some 82 percent of these cases have been successfully restructured.8 trillion had been completed. Corporate Debt Restructuring and Bankruptcy The 1997 crisis led to a severe liquidity problem in the economy. will be settled by the courts. Considerable progress has been achieved on this front. Another 5 percent of cases (B70 billion) are undergoing restructuring negotiations. Reforms in bankruptcy procedures should be seen not only in the context of crisis resolution. accounting for B1. accounting for B1. the number of cases has abated. CDRAC’s target debtors comprised 10. where bankruptcy procedures are swift and effective. In addition. The first bankruptcy court in Thailand opened on 18 June 1999. personal consumption. with the majority of the debtors coming from the commerce.147 cases (B1. only 7. and manufacturing sectors.6 trillion. 322. Another 77. and procedures for debt restructuring. the mere threat of external control alters the incentives faced by managers and controlling shareholders significantly. The Bank of Thailand issued guidelines in 1998 encouraging financial institutions to specify their own policies. As of November 2000. 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. By October 2000. as well as those that did not cooperate with CDRAC’s restructuring process. the Government introduced debt restructuring-related measures to help resolve bad debts.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. contributing to the unprecedented rise in the corporate sector’s bad debt. The reason is that bankruptcy law amendments appear to facilitate settlements outside the court.6 trillion) have agreed to cooperate with CDRAC’s restructuring process. methods.764 debt restructuring cases involving B1. Equally important is the contribution of effective and reliable bankruptcy procedures for improved corporate governance. In particular.068 cases involving B475 billion are undergoing restructuring. the court had more than 80 cases for disposition. However.1 trillion of outstanding credit.

The banking industry played a key role in the early stages of economic development because it represented the only avenue for funding Thai corporations. II Malaysia.270 Corporate Governance and Finance in East Asia. 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. Reforms through SET and Improved Disclosure The financial crisis prompted SET to introduce a range of improvements to its operation and regulation. despite the weakness of their disciplinary powers. In the next three decades. 4. It required listed companies to establish their own audit committees by the end of 1999. Weak bankruptcy procedures were part and parcel of the perverse set of incentives that led firms to build up unsustainable levels of debt. Financial information from listed companies will also soon be required to conform to International Accounting Standards.6 4. 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. behavior. Examination of corporate ownership.6. Such improvements in disclosure standards are part of the efforts of SET and SEC. The . to push companies to harmonize their accounting with international standards. the Government protected certain corporate sectors through tariffs and regulation. and Recommendations Summary and Conclusions This study has provided an overview of the corporate sector and governance in Thailand. and performance during this period helps understand the causes of the crisis. Philippines. Emphasis was on the structure of corporate governance and patterns of corporate ownership and financing of publicly listed companies. For this reason. Vol. and promoted key industries through incentives. The economic development of Thailand took off with the implementation of a series of National Economic and Social Development Plans beginning with the first medium-term plan for 1961 to 1966. and even Indonesia.1 Summary. The exchange has already required that listed companies’ quarterly reports be directly comparable with annual statements. The study covers the period 1985 to 1996. the Thai Government managed its economy with the corporate sector as the main engine of growth and development. Conclusions.

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

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

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

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

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

However. Accounting standards have also been under review. . Vol. There will be no incentive for companies to raise capital in the equities market if they can obtain funds at a lower cost elsewhere. there is a need to increase market disciplinary power through market competition. In the stock market. the power of the capital market to discipline inefficient management is almost nonexistent. II responsibility among companies. aimed at ensuring that banks finance only creditworthy projects. Because the financing of Thailand’s corporate sector is predominantly bank-based and will remain so for a long while yet. in turn. a well-developed secondary market will pave the way for market disciplinary forces to act against poorly managed companies. Further. The promotion of active roles for domestic institutional investors should also improve corporate governance in Thailand. A well-developed domestic debt market will provide corporations with an alternative to bank financing. The Bank of Thailand’s enforcement of prudent lending practices among Thai financial institutions. Thailand should develop a strong public debt market to supplement the banking system in financing corporate investments. it will be difficult to improve corporate governance in Thailand. Capital Market Development and Regulation Another important issue concerns the development of capital markets. especially in the area of connected lending. will incidentally close off easy sources of finance for companies that have been practicing regulatory arbitrage. 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. while a strong domestic debt market will also offer protection from foreign exchange risk. for instance. which. The first step is to establish an active secondary Government bond market. Without a strong and efficient capital market. the SEC’s disposition toward a largely voluntary approach for adoption of these characteristics has resulted in uneven compliance among public companies.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. will lead to the emergence of a reference yield curve. it is important to explore reforms that can lead to the enhanced role of banks in monitoring enterprises. In an environment of highly concentrated ownership. The same goes for improvements in the bankruptcy system.

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

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