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A Study of Indonesia, Republic of Korea, Malaysia,Philippines,andThailand
Edited by: Juzhong Zhuang SeniorEconomist RegionalEconomicMonitoringUnit AsianDevelopmentBank David Edwards AssistantChiefEconomist ProjectEconomicEvaluationDivision AsianDevelopmentBank Ma. Virginita A. Capulong SeniorSectorAnalyst AgricultureandSocialSectorsDepartment(West) AsianDevelopmentBank
© Asian Development Bank 2001 Allrightsreserved. ThispublicationwaspreparedundertheAsianDevelopmentBanksregionalTechnical Assistance 5802: A Study on Corporate Governance and Financing in Selected DMCs. The views expressed in this book are those of the authors and do notnecessarilyreflecttheviewsandpoliciesoftheAsianDevelopmentBank,or itsBoardofDirectorsorthegovernmentstheyrepresent. The Asian Development Bank does not guarantee the accuracy of the data includedinthispublicationandacceptsnoresponsibilityforanyconsequencesfor theiruse. Use of the term country does not imply any judgment by the authors or the AsianDevelopmentBankastothelegalorotherstatusofanyterritorialentity . ISBN 971-561-323-3 Publication Stock No. 100800 Published and printed by theAsian Development Bank P.O. Box 789, 0980 Manila, Philippines
List of Tables List of Figures Foreword Preface Abbreviations 1 Indonesia 1.1 Introduction 1.2 OverviewoftheCorporateSector 1.2.1 HistoricalDevelopment 1.2.2 TheCapitalMarket 1.2.3 The Banking Sector 1.2.4 ForeignCapital 1.2.5 GrowthandFinancialPerformance 1.2.6 LegalandRegulatoryFramework 1.3 CorporateOwnershipandControl 1.3.1 CorporateOwnershipStructure 1.3.2 ManagementandInternalControl 1.3.3 ExternalControl 1.4 CorporateFinancing 1.4.1 FinancialMarketInstruments 1.4.2 PatternsofCorporateFinancing 1.4.3 CorporateFinancingandOwnershipConcentration 1.5 TheCorporateSectorintheFinancialCrisis 1.5.1 CausesoftheFinancialCrisis 1.5.2 ImpactoftheFinancialCrisisontheCorporateand BankingSectors 1.5.3 Responses to the Crisis 1.6 Summary, Conclusions, and Recommendations 1.6.1 SummaryandConclusions 1.6.2 Policy Recommendations References vi ix x xi xii 1 1 3 3 4 5 7 8 15 17 17 25 30 32 32 34 35 36 36 39 42 45 45 48 51
2 Republic of Korea 2.1 Introduction 2.2 OverviewoftheCorporateSector 2.2.1 HistoricalDevelopment 2.2.2 Rise of the Large Business Groups (Chaebols) 2.2.3 RoleoftheCapitalMarketandForeignCapital 2.2.4 GrowthandFinancialPerformance
53 53 55 55 60 62 65
iv 2.3 CorporateOwnershipandControl 2.3.1 PatternsofCorporateOwnership 2.3.2 InternalManagementandControl 2.3.3 ShareholderRights 2.3.4 ControlbyCreditors 2.3.5 TheMarketforCorporateControl 2.3.6 ControlbytheGovernment 2.3.7 EmployeeParticipationinCorporateGovernance 2.4 CorporateFinancing 2.4.1 Overview of the Financial System 2.4.2 PatternsofCorporateFinancing 2.4.3 FinancialStructure,Diversification,andCorporate Performance 2.5 TheCorporateSectorintheFinancialCrisis 2.5.1 WeaknessesinCorporateGovernance 2.5.2 TheRoleofGovernmentIntervention 2.5.3 ManifestationsofWeakCorporateGovernanceand GovernmentIntervention 2.5.4 ShortcomingsinMacroeconomicPolicy 2.6 Responses to the Crisis and Policy Recommendations 2.6.1 CorporateRestructuringActivities 2.6.2 PolicyMeasuresforCorporateReform 2.6.3 Policy Recommendations References 3 The Philippines 3.1 Introduction 3.2 OverviewoftheCorporateSector 3.2.1 HistoricalDevelopment 3.2.2 GrowthandFinancialPerformance 3.2.3 LegalandRegulatoryFramework 3.3 CorporateOwnershipandControl 3.3.1 PatternsofCorporateOwnership 3.3.2 CorporateManagementandShareholderControl 3.3.3 TheRoleofCreditorsinCorporateControl 3.4 CorporateFinancing 3.4.1 TheFinancialMarketandInstruments 3.4.2 PatternsofCorporateFinancing 3.4.3 OwnershipConcentration,FinancialLeverage,and Performance 3.5 TheCorporateSectorintheFinancialCrisis 3.5.1 TheFinancialCrisis:CausesandManifestations 3.5.2 ImpactoftheCrisisontheCorporateSector 3.5.3 Responses to the Crisis 74 74 94 103 105 108 110 111 113 113 118 128 130 132 134 134 137 139 139 143 148 153 155 155 156 156 158 167 171 171 186 198 199 199 202 209 210 210 212 214
v 3.6 Summary, Conclusions, and Recommendations 3.6.1 SummaryandConclusions 3.6.2 Policy Recommendations References 216 216 219 226
4 Thailand 4.1 Introduction 4.2 OverviewoftheCorporateSector 4.2.1 HistoricalDevelopment 4.2.2 DevelopmentofCapitalMarkets 4.2.3 GrowthandFinancialPerformance 4.2.4 LegalandRegulatoryFramework 4.3 CorporateOwnershipandControl 4.3.1 PatternsofCorporateOwnership 4.3.2 CorporateManagementandControl 4.3.3 ExternalControl 4.4 CorporateFinancing 4.4.1 OverviewoftheFinancialSector 4.4.2 PatternsofCorporateFinancing 4.5 TheCorporateSectorduringtheFinancialCrisis 4.5.1 ImpactoftheFinancialCrisisontheCorporateSector 4.5.2 Responses to the Crisis 4.6 Summary, Conclusions, and Recommendations 4.6.1 SummaryandConclusions 4.6.2 Policy Recommendations References
229 229 230 230 233 235 239 240 241 244 248 252 252 257 261 261 264 270 270 273 277
4 Growth Performance of Publicly Listed Companies by Sector.16 FinancingPatternsofPubliclyListedNonfinancial Companies. 1993-1999 Table 1.1 Growth of the Banking Sector. 1990-1998 Table 1.17 DER of Listed Companies by Degree of Ownership Concentration Table 1.3 GrowthandFinancialPerformanceofPubliclyListed Companies. Indonesia Table 1. 1992-1998 Table 2. 1992-1995 Table 1.19 DER and ROE of Publicly Listed Companies by Sector. 1997 Table 1. 1990-1997 Table 1. 1996-1999 Table 1. 1992-1999 Table 1.1 Listed Firms with Positive Economic V alueAdded. 1992-1997 Table 1.10 Anatomy of the Top 300 Indonesian Conglomerates. Republic of Korea Table 2.9 OwnershipConcentrationofPubliclyListedCompanies by Sector. 1993-1997 Table 1.6 GrowthandFinancialPerformanceofState-Owned Companies.21 Nonperforming Loans by Type of Bank.5 Financial Performance of Publicly Listed Companies by Sector.20 ROE of the Banking Sector. 1996-1998 2. 1992-1997 Table 1.12 CharacteristicsoftheBoardofDirectors Table 1. 1996-1998 Table 1.14 Banking Sector Outstanding Loans.vi List of Tables 1.2 KeyMacroeconomicIndicators Table 2.15 V alue of Stocks Issued and Stock Market Capitalization.7 Growth Performance of the Top 300 Conglomerates. 1988-1996 Table 1.11 CharacteristicsoftheBoardofCommissioners Table 1.8 OwnershipConcentrationofPubliclyListedCompanies. 1992-1997 Table 1. 1992-1999 Table 1.18 GDP Growth by Sector. 1985-1998 6 7 9 11 12 14 14 18 19 21 26 27 28 32 33 34 36 39 40 41 41 54 56 61 63 . 1992-1997 Table 1.4 Development of the Stock Market.3 Subsidiaries of the 30 Largest Chaebols Table 2.2 Foreign Capital Flows. 1986-1996 Table 1.13 Presence of Board Committees in Listed Companies Table 1.
1993-1997 The Top 30 Chaebols Debt-to-Equity Ratio.10 Table 2. 1999 InternalShareholdingsofthe30Largest Chaebols. 1997 OwnershipConcentrationofListedNonfinancialFirms by Firm Size.8 Table 2. 1988-1997 OwnershipConcentrationofListedNonfinancialFirms by Industry.16 Table 2. 1994-1998 Financing Patterns of the Top 30 Chaebols. 1997 Ownership Composition of Listed Firms in Selected Countries.25 Table 2. 1992-1997 OwnershipConcentrationofListedNonfinancialFirms. 1988-1997 Features of the 30 Largest Chaebols GrowthandFinancialPerformanceofthe30Largest Chaebols.11 Table 2.29 Table 2.22 Table 2. 1990-1997 InternationalComparisonofRatiosofOrdinaryIncome toSalesinManufacturing GrowthandFinancialPerformanceofSelectedIndustries GrowthandFinancialPerformanceofListedCompanies.18 Table 2. 1997 Ownership Concentration ofAll Listed Firms.17 Table 2.vii Table 2. 1995-1997 Ownership Composition of Listed Companies.15 Table 2.24 Table 2. 1988-1997 Ownership Concentration of the Survey Sample of 81 Listed Firms.19 Table 2. 1987-1997 FlowofFundsoftheNonfinancialCorporateSector.13 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 .20 Table 2.26 Table 2.21 Table 2.6 Table 2.7 Table 2.27 Table 2.14 Table 2.9 Table 2.30 Private Capital Flows to Korea. 1985-1997 GrowthandFinancialPerformanceofListedCompanies by Size. 1994-1997 Cross-Payment Guarantees of the Top 30Chaebols. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSectorby Industry Financing Patterns of Listed Companies. 1990 and 1997 Ownership Composition of Listed Nonfinancial Firms by Size. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSector.28 Table 2. 1985-1998 GrowthandFinancialPerformanceoftheNonfinancial Corporate Sector.23 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.12 Table 2.
1997 Table 3.15 Financing Patterns of the Corporate Sector.14 Philippine Stock Market Performance.Profitability andFinancial . 1995-1998 4. 1988-1997 Table 3.11 TotalandPerCompanySales.33 Net Profit Margins of Chaebols.3 TheCorporateSectorandGrossDomesticProduct. 1997 Table 3.1 Public Companies Registered.18 Financing Patterns by Control Structure. 1988-1997 Table 3.4 GrowthandFinancialPerformanceoftheCorporateSector by Ownership Type. 1997 Table 3.viii Table 2. 1988-1997 Table 3. 1978-2000 Table 4. 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 3.000 Companies.13 ADB Survey Results on Shareholder Rights Table 3. Flagship Company. The Philippines Table 3.8 Ownership Composition of Philippine Publicly Listed Companies by Sector. 1988-1997 Table 3. 1989-1997 Table 3.21 OwnershipConcentration.31 Table 2.9 OwnershipConcentrationatCriticalLevelsofControl Over Publicly Listed Companies. andAffiliated Banks of Selected Business Groups.6 GrowthandFinancialPerformanceoftheCorporateSector by Firm Size. 1988-1997 Table 3.SectorOrientation. 1997 Table 3.7 GrowthandFinancialPerformanceoftheCorporateSector by Industry.19 Financing Patterns by Firm Size.17 Composition ofAssets and Financing of the Publicly Listed Sector. 1992-1996 Table 3.5 GrowthandFinancialPerformanceoftheCorporateSector by Control Structure.1989-1997 Table 3. 1989-1997 Table 3.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.2 Public Offerings of Securities. 1985-1997 Number of Firms with Dishonored Checks. Leverage Table 3.12 Control Structure of the Top 50 Corporate Entities.16 CorporateFinancing PatternsbyOwnershipType. 1988-1997 Table 3.1 GDP Growth of SoutheastAsian Countries. 1990-1999 Table 3. Thailand Table 4.32 Table 2. 1997 Table 3. 1986-1998 Nonperforming Loans of General Banks.22 Foreign Investment Flows. 1992-1999 .20 Financing Patterns by Industry. 1989-1997 Table 3. 1989-1997 Table 3.2 Growth and Financial Performance of the Top 1. 1983-1997 Table 3.
1990-1996 Common-Size Statements of Public Companies by Ownership Concentration.3 Table 4. 1990-1998 Merger and Acquisition Activities.12 Table 4.17 StatisticalHighlightsoftheStockExchangeofThailand. 1990-1998 StatisticalRelationshipsbetweenCorporateProfitability. 1990-1996 Financial Ratios of All Listed Firms.10 Table 4.13 Table 4. 1992-1999 Offerings of Debt Securities.15 Table 4.11 Table 4.1 Figure 3.1 Figure 1. 1993-1999 Key Financial Ratios of Publicly Listed Companies. and Company Size Top-Five Shareholder Composition of Publicly Listed Companies in Thailand. 1986-1999 NumberofNewlyRegisteredandBankrupted/Closed Companies.7 Table 4. 1993-1999 Size and Composition of the Thai Financial Sector.8 Table 4. 1985-1999 237 238 239 241 242 243 251 252 256 258 259 260 261 262 264 List of Figures Figure 1. Leverage.16 Table 4.9 Table 4. 1992-1999 Common-Size Statements for Companies Listed in SET.ix Table 4. 1985-1996 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand.5 Table 4. 1990-1996 Financial Ratios of Listed Companies by Ownership Concentration.4 Table 4. 1985-1996 Average Key Financial Ratios by Company Size.2 TheSuhartoGroup TypicalInternalOrganizationalStructureofaPublicly Listed Company in Indonesia CorporateControlStructure:TheCaseofAyalaCorporation CorporateControlStructure:theCaseofLopezGroup 24 25 195 197 .6 Table 4. Ownership Concentration. 1990-1996 External Debt.14 Table 4.2 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 supportADBs financialsectorworkinitsdevelopingmembercountries.
Arvind Panagariya ChiefEconomist
Corporate Governance and Finance in EastAsia presents the findings of a regionalstudyofcorporategovernanceandfinanceinselecteddevelopingmember countries of theAsian Development Bank (ADB). The study attempts to identify theweaknessesincorporategovernanceandfinanceincountriesmostaffected by the 1997Asian financial crisis, and recommends policy and reform measures to address the weaknesses. The study covers Indonesia, Republic of Korea, Malaysia, Philippines, and Thailand. The findings of the study are presented in two volumes. Volume One,A ConsolidatedReport,presentsaframeworkforanalyzingcorporategovernance and finance, summarizes the major findings of the five country studies, and provideskeypolicyrecommendationsforstrengtheningcorporategovernanceand improving the efficiency of corporate finance inADB member countries. Volume Two,CountryStudies,collectsfourcountryreports.Wewouldliketothankcountry experts Saud Husnan of Gadsab Mada University, Indonesia; Kwang S. Chung andYen Kyun Wang of Chung-Ang University, Republic of Korea; FazilahAbdul Samad of University of Malaya, Malaysia; Cesar G. Saldaña of PSR Consulting, Inc., the Philippines; and Piman Limpaphayom of Asian University of Science and Technology, Thailand, for their efforts and cooperation in conducting the countrystudies.CesarG.Saldañaalsoprovidedusefulinputstothepreparation oftheconsolidatedreport. The volumes benefited extensively from constructive comments from ADBstaffandofficialsoftheministriesoffinance,centralbanks,securitiesand exchangecommissions,stockexchanges,andcorporaterestructuringagenciesof theeightADBmembercountriesthatparticipatedinthestudysfinalizationworkshop in Manila, on 18-19 November 1999. Our deep appreciation goes to Jungsoo Lee, former Chief Economist, and S. Ghon Rhee, former Resident Scholar, for their strong support at various stages of the study; Manabu Fujimura, for his efforts in organizing the finalizationworkshop;MarceliaGarcia,MarinieBaguisa,Ma.ReginaSibal,andRosanna Benavidez, for their administrative support and assistance; and JosefYap, Leah Sumulong, Graham James Dwyer, Judith Banning,andLynetteMallery, for their editorialassistanceandadvice.
ADB AGM AGSM AMU APEC B BDC BIBF BIS BOC BOD BSDC BSP BUN CB CDRAC CEO CP CRA DER ESOP EVA FDI FSC GAAP GATT GDP GNP HCI IBRA IDFR IEFR IFS IMF IPO IPP JSX NBFI NEFR NPL OECD OTC Asian Development Bank annualgeneralmeeting annualgeneralshareholdersmeeting assetmanagementunit Asia-Pacific Economic Cooperation baht Bond Dealers Club BangkokInternationalBankingFacility BankforInternationalSettlements board of commissioners boardofdirectors BangkokStockDealingCenter BangkoSentralngPilipinas(CentralBank) Bank Umum Nasional convertiblebond CorporateDebtRestructuringAdvisoryCommittee chiefexecutiveofficer commercialpaper CorporateRestructuringAgreement debt-to-equityratio employee stock ownership plan economicvalueadded foreigndirectinvestment Financial Supervisory Commission generallyacceptedaccountingprinciples GeneralAgreementonTariffsandTrade grossdomesticproduct grossnationalproduct heavyandchemicalindustries IndonesianBankRestructuringAgency incrementaldebtfinancingratio incrementalequityfinancingratio InternationalFinancialStatistics InternationalMonetaryFund initialpublicoffering investmentprioritiesplan JakartaStockExchange nonbankfinancialinstitution newequityfinancingratio nonperformingloan OrganisationforEconomicCo-operationandDevelopment over-the-counter
xiii P PCO PD PICPA PLDT PSE PTB ROA ROE Rp RSA SBL SCS SEA SEC SET SFR SMC SSS SOC TIE TQ W US peso planningandcoordinationoffice PresidentialDecree PhilippineInstituteofCertifiedPublicAccountants Philippine Long Distance Telephone Co. Philippine Stock Exchange principaltransactionsbank returnonassets returnonequity rupiah Revised SecuritiesAct singleborrowerlimit shareofacontrollingshareholder Securities and ExchangeAct Securities and Exchange Commission StockExchangeofThailand self-financingratio SanMiguelCorporation Social Security System State-ownedcompany timesinterestearned Tobins Q won UnitedStates
Note: In this volume, $ refers to US dollars, unless otherwise stated.
The currency crisis that began in mid-1997 in Thailand spread quickly to Indonesia and the rest of Southeast Asia. Initially, Indonesia’s monetary authority tried to defend the domestic currency, the rupiah, by widening the intervention band, while maintaining its managed floating system. From 5 to 8 percent in June 1997, when the currency crisis hit Thailand, the band was widened to 12 percent on 11 July 1997 when the crisis started spilling over to Indonesia. After resisting pressure for a short period, the rupiah fell by 6 percent against the dollar on 21 July 1997, the biggest one-day fall in five years. Finally, the Indonesian monetary authority realized that the system could not cope with the continuing pressure on the currency, as the risk of losing all foreign exchange reserves to prop up the rupiah was too high. On 14 August 1997, the monetary authority decided to adopt a free floating exchange rate system. The currency fell further because of strong demand for dollars. As the rupiah weakened, nervous lenders refused to refinance maturing loans, investors cut down and then reversed the flow of funds, borrowers tried to obtain dollars before the rupiah fell further, and individuals joined the chase for dollars. At that time, several banks ran out of dollar notes. From Rp4,950 to the dollar at the end of December 1997, the exchange rate fell to more than Rp15,000 at the height of the crisis in June 1998, although it later stabilized at about Rp9,000. At that exchange rate, it is estimated that half of Indonesian corporations became technically insolvent. The crisis also exacerbated an already deepening political turmoil. The financial crisis devastated the Indonesian economy. In 1998, gross domestic product (GDP) contracted by 13 percent and the inflation
Associate Professor, Faculty of Economics, Gadsab Mada University, Yogyakarta, Indonesia. The author wishes to thank Juzhong Zhuang, David Edwards, both of ADB, and David Webb of the London School of Economics for their guidance and supervision in conducting the study, the Jarkata Stock Exchange for its help and support in conducting company surveys, and Lea Sumulong and Graham Dwyer for their editorial assistance.
and . or Thailand.5 percent. the currency composition and term structure of corporate foreign indebtedness were causes for concern. On the other hand. However. Economic growth reached more than 7 percent per year and the inflation rate was kept at single digit levels. 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. When the crisis hit the country. and how it contributed to the crisis. These were already contributing to high levels of nonperforming loans (NPLs) in the Indonesian banking sector several years before the 1997 crisis erupted. II rate reached 58. placed a high premium on these political connections in assessing the chances of being repaid.6 percent) and trade (-18 percent). patterns of financing. the controlling families of corporate groups often established banks to provide funds to affiliated nonfinancial companies. particularly those with large foreign loans. and responses to the financial crisis. Vol. regulatory framework. no doubt. It analyzes the weaknesses of corporate governance in Indonesia.5 percent. the Indonesian economy seemed to be in generally good shape. short-term loans were used to finance long-term investments. These banks were allowed to operate even if they violated minimum capital adequacy requirements. In this setup.2 presents an overview of the Indonesian corporate sector. In many instances. To facilitate even easier access to credit. followed by finance (-26. were the ones most affected. these controlling families had political connections that allowed their companies to enjoy special privileges. and analyzes their importance to the corporate sector in Indonesia. The study also identifies family-based companies and corporate groups. Malaysia.3 looks at patterns of corporate ownership and control. contracting by 36. Foreign debt reached more than $100 billion.2 Corporate Governance and Finance in East Asia. highly leveraged companies. this left the Indonesian economy extremely vulnerable. posted negative growth. Lending activities of affiliate banks that were not sufficiently backed by owners’ equity and the reliance by foreign lenders on the strength of political connections paved the way for risky investments. The scale of the financial crisis exposed weaknesses of the country’s corporate sector. All sectors. Foreign creditors. This study reviews the Indonesian corporate sector’s historical development. patterns of ownership and control. how it has affected corporate financial performance and financing. 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. Section 1. The construction sector was the worst hit. except utilities. Section 1. prior to the financial crisis.
Despite the oil revenues. In the early 1970s. while Chinese and indigenous entrepreneurs ran some large businesses in trading. . It also examines the statistical relationship between corporate performance and corporate governance characteristics. This section reports the results of an Asian Development Bank (ADB) survey on corporate management and control practices in Indonesian publicly listed companies. and its response. medium. only 40 companies replied—39 are private companies and one state-owned company (Bank BNI).6 summarizes the major findings of the study and suggests recommendations to improve governance in the Indonesian corporate sector. Section 1. Subsequently.5 examines the corporate sector during the financial crisis in terms of its role. With the relatively liberal laws governing foreign and domestic private investments introduced by the New Order Government in 1967 and 1968. how it was affected by the crisis.Chapter 1: Indonesia 3 profiles the corporate sector’s governance characteristics. 2 Survey questionnaires were sent to 280 companies listed in the Jakarta Stock Exchange. textiles. The industries that emerged were highly import-dependent and reliant on tariff protection. The Government became directly involved in industry as a result of the nationalization of Dutchowned shipping firms and oil companies. and tobacco industries. Section 1. Up until the mid-1960s.4 analyzes corporate financing patterns. substantial volumes of private investment entered the scene. in the course of the fight for nationhood from 1942 to 1950. Not all items in the questionnaires were answered by the respondents. 1.1 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. a gradual shift in public investment away from manufacturing took place.and large-scale companies were dominated by state-run industrial concerns.2 1.2.2 Section 1. the windfall from oil and gas revenues was an important factor that allowed the Government to promote industrial development via import substitution. However.
the stock exchange was also unattractive to companies trying to raise capital as they could borrow from state banks at very low interest rates. First. But these proved counterproductive because they limited the potential for capital gains to prospective investors. potentially subjects companies to greater regulatory scrutiny. there were also many rapidly growing large-scale companies and business groups or conglomerates. II the currency needed to be devalued periodically under a managed floating exchange rate system to avoid large current account deficits. Vol. many founding owners of companies were reluctant to go public and dilute their corporate ownership. Partly as a result of various government policies. which dominated their respective sectoral outputs and markets. wood. a distinct industrial elite started to emerge.2 The Capital Market The Government reactivated the stock exchange in 1977. Regulations in the banking sector led to equities having higher risk but lower returns than bank deposits. the Government shifted its industrial policy toward the promotion of labor-intensive exports. and employed the bulk of the industrial labor force.2. By 1987. During this period. While most of the companies were small. A number of underwriters emerged. Generally speaking. Third. the value of manufactured exports overtook the value of oil and gas exports for the first time. Last. produced consumer goods. 1. In 1992. and related products) had shares in total exports that were rapidly increasing. the Indonesian industrial sector was quite diverse. These were families with strong links to the political elite of the New Order. Second. exports of nonoil products (particularly textiles and footwear. 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. The equity market remained largely unappealing due to a number of factors. But until the end of 1988. the number of firms quoted in the stock market was only 24. In the 1980s. 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). mostly nonbank financial institutions and stockbrokers.4 Corporate Governance and Finance in East Asia. even when new shareholders do not threaten the control exercised by the original owners. 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.
the legal infrastructure that was supposed to guide the evolution of the banking sector was not backed by effective enforcement. the liberalization of the banking industry allowed banks to determine lending rates for nonpriority loans. with a total value of Rp16. These included the opening of the banking industry to new entrants. During this period. The development of the Indonesian stock market also provided a vehicle for the privatization of state-owned companies (SOCs). The initial banking sector reform was introduced in 1983. the controlling shareholder of these SOCs is still the State. from 24 in 1988 to more than 300 in 1997. Since 1977. six SOCs had issued equities in the market. Thus. state-owned banks were still among the biggest.Chapter 1: Indonesia 5 At the end of 1988.2. the capital market played an increasing role in raising long-term funds needed by the corporate sector. the banking sector has been and still is the major source of credit for the corporate sector. reduced restrictions on foreign exchange transactions. Conglomerates carried out 210 out of 257 IPOs. However. began to face competition. However. the number of private domestic banks increased. priority credits still enjoyed subsidized interest rates and funding from the Central Bank. Interest rate regulations on state banks and credit ceilings in general were removed. The Government also allowed foreign investors to buy up to 49 percent of listed shares. to date. the number of listed companies in the stock exchange increased substantially.3 The Banking Sector Despite the development of the stock market. with a total value of more than Rp8 trillion. Partly as a result of these reforms. companies could no longer enjoy low-interest credit from state banks. However. 1. . private domestic banks dominated the sector in terms of number and total assets. and increased access of domestic banks to international financial markets. which were previously constrained to 4 percent per day.5 trillion. The banking sector. Consequently. Table 1. But in terms of assets per bank. Through the years. In 1988. The Government also abolished the practice of setting prices for IPOs and removed restrictions on price movements in the secondary market. which up to then was channeling oil revenues to priority sectors.1 shows that from 1994 to 1998. Further reforms along the same direction and affecting state-controlled banks came in the 1990s. the banking sector has undergone many reforms. The dominance of state banks started to erode. more significant reforms were introduced.
5 528.7 351.8 10 19.3 10 17.5 27 88.9 31 9. The other banks among the top 10 were state banks.9 762.2 10 14.6 34 14.8 31 10.5 7 7 7 5 15.3 30 7. while BUN has been closed down by the Government.9 10 11. Of these. In terms of assets.1 Growth of the Banking Sector.2 161 214.9 39 18. .4 239 222 208 173 Assets and liabilities were concentrated in the top 10 banks.1 240 1995 122.4 34 12.8 27 200.9 27 113.8 29 6. Vol.8 10 37.6 240 1996 1997 1998 1999 141.5 165 308.6 7 12. II Table 1. and Bank International Indonesia (ranked 9th).4 789.8 166 248. But the banking system proved incapable of performing its intermediation function. and Bank Umum Nasional (BUN) have failed and the first two are now under management of the Indonesian Bank Restructuring Agency (IBRA). BCA.8 27 147.9 304. the 10 largest were all affiliated with major business groups.6 164 144 130 92 387. 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. Bank Danamon (ranked 7th).0 234 1994 104.6 7 7. Both BCA and BUN have shareholders linked to the former President Suharto.9 248.7 27 37.3 201. banks could earn profits even when they did not gather and process information about risk.8 391. Among private domestic banks. 1993 100.1 10 47. private domestic banks among the top 10 in 1997 included Bank Central Asia (BCA) (ranked first and linked to the Salim group).3 27 51. The deregulation of the banking industry and the liberalization of the capital account created a variety of new sources of financing for the corporate sector.9 291.4 10 35.5 7 9.6 Corporate Governance and Finance in East Asia.5 27 66. Because regulation was weak. Bank Danamon.
IMF. when the financial crisis hit Indonesia. foreign creditors were eager to provide financing to Indonesia.09) 1.50 (0.48 1.09 1. Between 1990 and 1996. But FDIs were only one form of foreign capital inflows to Indonesia.00 2.09) (0. 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. Table 1. the Government allowed foreign investors to own 100 percent of an Indonesian company. they still amounted to a large sum for the economy to absorb.40) (0. In the 1990s.15) — = not available. In effect.10 5.11 3.2. Most FDIs came in through joint ventures with business groups having strong political connections. such as metal goods.2. From the mid-1980s until July 1997.4 Foreign Capital The years of rapid industrial growth attracted a large amount of foreign direct investments (FDIs). initially from Japan and the Republic of Korea. .59 4. November 2000. Increasingly. FDI flows were strong.59 billion in 1996.01) (0. Until the onset of the crisis.87 7.88 4. especially through bank loans. and footwear. foreign investment also had a strong presence in the services and infrastructure sectors. 1. In 1994.2 Foreign Capital Flows. Source: IFS CD-ROM.63) (1. Net FDI flows increased to $5. September 2000. Successive policy deregulation facilitated FDIs in various light manufacturing industries. Although these inflows were not nearly as large as those received by Thailand (10 percent of GDP) and Malaysia (9 percent of GDP).33 (13.Chapter 1: Indonesia 7 Foreign and domestic banks defaulted on their responsibility of deciding where capital should go and ensuring that it was used in the most effective way.81 3. except in certain strategic sectors.78 2.88) — — — — — — 8. there was a phenomenal growth in direct borrowings by Indonesian corporations.01 (2.74 5. Indonesia received capital inflows averaging about 4 percent of GDP. as shown in Table 1. 1990-1998 ($ billion) Type of Flows Net FDI Net Portfolio Investment Foreign Bank Loans 1990 1991 1992 1993 1994 1995 1996 1997 1998 1. Joint BIS-IMF-OECD-World Bank Statistics on External Debt. textiles.
By the end of 1997.8 Corporate Governance and Finance in East Asia. 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.5 Growth and Financial Performance While it was obvious that the term structure and currency composition of debt suggested problems in the run-up to the crisis. The 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. Consequently. Private borrowers preferred foreign loans since these were relatively cheaper.2. The excessive dollar borrowings made the corporate sector vulnerable to sudden currency fluctuations. . and conglomerates. Domestic corporate debt was about $50 billion equivalent. The following section looks at the growth and financial performance of the corporate sector. From 1987 to 1996. Capital account liberalization permitted the inflow of foreign capital that fueled the credit boom in the country.4 trillion in 1997. an interesting question is whether standard measures of corporate profitability and performance also indicated the same. This increased to 30 percent by the end of 1993. The Government relaxed this restriction in 1988. but declined to an average of 25 percent during 19951997. This is lower than the average borrowing rate of 18 percent for loans in domestic currency. In the 1990s. increasing the total trading value from Rp8 trillion in 1992 to Rp120. foreign investors began to dominate daily trading. of which two thirds were rupiah-denominated. 1. with the onset of the Asian crisis. the limit on foreign portfolio investment was removed and foreign investors were allowed to buy up to 100 percent of shares of a listed Indonesian company. the analysis focuses only on publicly listed companies. the average borrowing rate for dollar loans was 9 percent. Due to data constraints. II Up until the late 1980s. In November 1998. plus 4 percent for the depreciation of the rupiah. state-owned companies (SOCs). In September 1997. the average foreign ownership of listed companies was 21 percent. Between 1989 and 1992. total corporate debt reached nearly $118 billion. allowing foreign investors to buy up to 49 percent of stocks of a publicly listed company. participation in the Indonesian stock market was exclusive to domestic investors. Vol. The external corporate debt owed to foreign commercial banks was $67 billion. foreign banks became a significant source of financing for the corporate sector. especially the short-term ones.
Return on assets (ROA) was also relatively stable during 1992-1996. total sales of listed companies grew at an annual average rate of 31 percent.1 220.3 6. The growth of listed companies was sustained by continuing investments. but turned negative in 1997.5 34. but declined to 0. while total assets grew at 43 percent. The debt-to-equity ratio (DER) was high compared to those of listed companies in Malaysia and the Philippines.4 31. 174 firms. 248 firms.2 30. Table 1. Source: JSX Monthly (several publications). averaging 3.2 7. but fell to 24.0 33.4 38.6 24. 226 firms.8 220.6 percent in 1997. Average return on equity (ROE) of listed firms was 11.0 64. 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. During 1992-1997. the average DER increased to 310 percent from 230 percent the .5 34.0 11. 1995.Chapter 1: Indonesia 9 Publicly Listed Companies Table 1. publicly listed companies as a group contributed less than 10 percent to GDP.3 shows the growth and financial performance of Indonesian publicly listed companies.1 4.7 3. although the contribution increased over time.7 percent in 1997. but dropped to 1. 246 firms.4 1997 7.8 230. there were 204 firms.5 240.7 — = not available.5 37.0 12.0 1.2 1995 37. 1994. ranging from 220 to 250 percent between 1992 and 1996. 1993.0 3.3 3.9 37.7 — 250.0 10.4 percent. a Value added was assumed to be 30 percent of total sales.6 48.4 1993 45. Despite such rapid growth.6 1994 50. b Asset turnover is defined as sales over assets.8 6. 250 firms. Net profits grew at an annual rate of more than 20 percent from 1992 to 1996.0 6.8 percent between 1992 and 1996. 1996. Note: The number of firms is not identical for each year.9 310. In 1997.4 1996 18. and 1992.0 12. When the crisis battered Indonesia in 1997.1 0.1 percent in 1997 when the crisis began to buffet Indonesia.5 3.6 3.0 12.3 Growth and Financial Performance of Publicly Listed Companies. Asset turnover was above 30 percent until 1996.
73 percent in 1992 to 1. ROE fell drastically because the sector had one of the highest DERs. averaging 21.2 in 1997. the mining sector ranked first. the property sector was severely affected by the crisis. and building construction. Four sectors (basic industry and chemicals. and services. miscellaneous industry. although asset turnover was slow. indicating its reliance on equity to support growth. it appeared that the performance of listed companies was quite satisfactory prior to the crisis.10 Corporate Governance and Finance in East Asia. Before the crisis.4). ROA of all sectors dropped in 1997. This sector was less affected by the crisis. During those years. For instance. The consumer goods sector ranked second in terms of ROE. the mining sector had the lowest DER. real estate. property. the fluctuation in nickel and copper prices contributed to the oscillation of ROE. and services. Table 1. and building construction sectors had the highest DERs because companies in these sectors found it easy to obtain credit from banks. Also. trade. with ROE falling to -11.7 percent during 1992-1996. From 1995. real estate. increased from 0. consumer goods. helped in part by the relatively strong demand for consumer goods. In terms of sales and asset levels in 1997. due mainly to the domination of the International Nickel Company of Canada. The ROE levels suggest that high leverage enabled listed companies to achieve high returns on equity. followed by agriculture (Table 1.5 presents the financial performance of listed companies by sector. basic industry and chemicals. the mining sector had the highest ROE. finance. only two sectors (mining and finance) showed a consistently increasing trend from 1992. the companies in the sector did not operate with a high leverage. The finance sector’s contribution to GDP. But the sector’s ROE fluctuated a lot. still posting a positive but lower ROE. mining. The finance.64 percent in 1997. averaging 17. In terms of share of value added to GDP. The same applied to the trade sector. When interest rates increased. which operated in nickel and copper mining in 1992 and 1993. investment. in terms of growth of sales and assets. Overall. and property. meanwhile. II previous year. This indicates that a substantial part of corporate debt was denominated in dollars and unhedged. miscellaneous industry. Most companies in the sector that had unhedged dollar-denominated loans suffered exchange rate losses when the rupiah weakened.3 percent between 1992 and 1996. the dominant sector was the finance sector. Meanwhile. when the property sector was booming during 1993-1997. the banks eagerly provided credit to property development companies. and trade. and trade) even posted . investment. However. The Jakarta Stock Exchange (JSX) classified listed companies into nine sectors: agriculture. infrastructure. property. Vol.
2 14. Constn..6 85.1 28.5) 6.1 — 39.9 0.6) 25.3 0.4 170.0 16.3 31.0 0.8 29.1 0.1 1.2 0.3) 39.9 123.2 13.7 0.1 1.7 — 36.8 27.3 0.5 9.7 133.8 51. Investment.4 38.8 (76.7 54. Real Estate.4 43.4 44. and Bldg.4 77.7 — — 11.9 54.3) 53.1 71.2 35. Infrastructure Finance Trade.6 15.2 41. Constn.7) 26.6 83.4 0. 1992 — — — — — — — — — — — — — — — — — — — — — — — — — — — 0.8 62.5 0.9 53.2 41.6) 19.2 11.9 8.1 42.6 0. and Bldg.1 32.5 1.4 21.7 34.4 31.8 24.0 0.5 1.3 92.5 95.6 0.0 31.6 0.4) 6. Investment.8 1.5) 49.3 0.6 (0.3 340.1 23.Table 1. Infrastructure Finance Trade. 1992-1997 (percent) Indicator/Sector Sales Growth Agriculture Mining Basic Industry and Chemicals Misc. and Services — = not available.3 17.5 68.4 Growth Performance of Publicly Listed Companies by Sector.9 .7 90. Real Estate. Industry Consumer Goods Industry Prop.9 (7.5 92.5 45.0 0.6) 119. and Bldg.4 103.2 5.5 1. Industry Consumer Goods Industry Prop. Constn.0 0.0 18.7 43. and Services Net Profit Growth Agriculture Mining Basic Industry and Chemicals Misc.5 (11.9 64.9 1.1 0.5 61.5) 13.8 50.7 28.0 (20.4 1.9 14.1 0.8 32.5 13.0 43.7 40. and Services Asset Growth Agriculture Mining Basic Industry and Chemicals Misc.8) 0..1 0. Industry Consumer Goods Industry Prop.6 (41.7 17.0 1.1 0.4 64.0) 46.4 1.0 (192.7 62.0 (28. Infrastructure Finance Trade.6 28.1 16.1 0.4) 8.9 0.1 1.6 133. and Services Share of Value Added in GDP Agriculture Mining Basic Industry and Chemicals Misc.6 1.5 23.6 1994 (75.8 0. Infrastructure Finance Trade.0 0.5 28.8 1.9 36.2 0.0 22.5 53. Real Estate.0 24.0 64.8 66.3 0.6 22.1 (41.1 67.7 1995 51.9 31.9 54. and Bldg.3 (203.4 (149.4 30.7 112.4 30.1 0. Constn.5 0.6 24.4 1.7 24.7 21.6 26.1 1.3 51.7) (27.1 0.3 31.9 25.1 35.5 (8.8 28. Real Estate.2) 0.7) (113. Source: JSX Monthly (several publications).9 59.7) 17.1 1.6 135.0 1996 1997 58.7 (82.6 0. Investment.1 0. Investment.3 0.2 59.3 1.0 68.8) (12.6 51..4 1993 155.. Industry Consumer Goods Industry Prop.1 (11.7 0.1 0.0 0.
8 479.5 7.2) 15.7 71. and Services Asset Turnover Agriculture Mining Basic Industry and Chemicals Misc.1 4.6 8. Industry Consumer Goods Industry Prop.0 630.2 3.3) 5.0 50.7 5.5 19.7 8.0 120. Constn.0 650.0 650. Investment.0 180.7 8.6 8.2 13. and Services Source: JSX Monthly (several publications)..8) 8.1 1994 80.1 63.5 5.0 110. Constn.2 7.9 7. Infrastructure Finance Trade.9 4.0 190.0 80.0 110. and Services Return on Assets Agriculture Mining Basic Industry and Chemicals Misc.8 11.0 130.7 1.0 110. Infrastructure Finance Trade.8 5.5 11.1 11.0 190.2 111.0 150.2 6.0 80.4 71.0 70.4 6. Industry Consumer Goods Industry Prop.0 190.3 18.1 10.3 73.4 4.9 29.4 35.5 4.0 110.7 4.0 70.0 17.0 180.3 1.0 8.6) 36..3 7.5 4.3 17.3 64.0 110.1 9.0 3.1 1.1 3.8 11.4) (1.6) 18.0 150.1 89.5 1995 80.7 10.9 17.8 25.2 53.4 13.0 170.2 39.1 8.0 11.9 38.0 210.9 10.6 18.4 79.0 60.1 (3.4 35.0 120.0 140.6 (11.9 14.5 13.2 8.0 46.0 100.0 700.0 (0.7 13.0 8.0 90.0 560.8 16.6 74.5 43.4 5. Real Estate.3 7.3 38. Industry Consumer Goods Industry Prop.5 56.3 13.2 15.0 86.5 17. 1992 20.0 110.6 (2.7 1.7 10.7 10.9 42.7 12.0 120.3 5.0 100. and Bldg.2 23.0 160.6 23.0 160.0 39.3 17. Real Estate.4 6.0 70.4 .0 180.7 9.2 1993 130.7 26.7 61.7 12.0 160.1 1996 100.8 3.8 382.0 220.0 3.8 20. and Services Return on Equity Agriculture Mining Basic Industry and Chemicals Misc. Investment.0 680.0 14.4 13.1 10. and Bldg..2 11.6 13.3 33.2 3.6 13. and Bldg.Table 1.2 30.4 46.0 380.6 14.8 9. Constn.6 1.0 66.0) 7.5 14.4 20.2 (4..0 19.0 15.7 4.9 40.6 19.9 38. Industry Consumer Goods Industry Prop.8 67.0 150. Investment.1 7. and Bldg.0 120.0 100. Real Estate.0 12.9 87.3 0. Real Estate.2) 7.0 69.8 168.8 81.7 4.1 2.1 4.0 1997 230.7 5.9 41.7 12.1 4.8 44.1 13.5 Financial Performance of Publicly Listed Companies by Sector.0 140.4 1. 1992-1997 (percent) Indicator/Sector Debt-to-Equity Agriculture Mining Basic Industry and Chemicals Misc.2 7.0 9.7 (3. Investment. Infrastructure Finance Trade. Constn.7 46. Infrastructure Finance Trade.1 9.0 110.8 8.1 65.1 (5.4 17.0 80.4 46.0 100.1 10.1 6.
The Department of Mining and Energy ranked first in terms of sales of SOCs under its control. which collectively had the largest assets. Similarly. SOCs actively operated in various sectors4 under the supervision of “technical” departments. SOCs’ sales growth fluctuated during 1990-1996. ROA had been at high levels from 1992 to 1995. For instance. banks (seven companies). much lower than that of companies listed in the stock exchange. averaging 24 and 31 percent. SOCs’ ROE ranged from 6. and basic industry and chemicals sectors had relatively stable ROA before the crisis. the Department of Finance supervised 30 SOCs. This was due to large sales by the National Oil Company (Pertamina). insurance (11 companies).3 trillion.1 percent in 1993. While asset turnover rates of publicly listed 3 4 SOCs are those in which the State has at least a 51 percent equity interest. By 1995. The sectoral distribution of 165 SOCs is as follows: nonfinancial (143 companies).6 to 8. indicating SOCs’ declining contribution to GDP. the subsidiaries and affiliates number 459 with total assets of Rp343. respectively. The DER was slightly higher than for listed companies.7 to 7 percent for publicly listed companies. SOCs diversified into many businesses.6). increasing from 21. Six SOCs were listed in the Jakarta Stock Exchange.Chapter 1: Indonesia 13 negative ROA. the SOCs’ value added as a percentage of GDP ranged from 6 to 8. However.7 percent. but dropped dramatically to 4. State-Owned Companies At the end of 1995. Just like private companies.3 percent in 1995. between 1993 and 1995.1 percent in 1992 to 28. These growth rates were low compared to those for listed companies during the same period. .8 percent between 1992 and 1995 (Table 1. Only the agriculture sector showed an increase in ROA in the couple of years before 1997.7 percent in 1990 to 6 percent in 1996. Assuming a fixed ratio of value added to sales. the ratio decreased from 8. registering an average annual rate of 10 percent. there were 58 SOCs with subsidiaries and affiliates. Trade had the highest ROA of 39. but it continuously declined from 370 percent in 1992 to 250 percent in 1995. Taken together. The finance and miscellaneous industry. and finance company (four companies). growth of net profits and assets was erratic.4 percent the following year. Asset turnover rates were lower relative to those of publicly listed companies. there were 165 state-owned companies (SOCs)3 in Indonesia. This was relatively high compared to the 3.
Table 1.14 Corporate Governance and Finance in East Asia.4 13.2 — = not available.3 30.6 Growth and Financial Performance of State-Owned Companies. 1990-1997 (percent) Item Sales Growth Share of Value Added in GDPa 1990 1991 1992 1993 1994 1995 1996 1997 — 17.3 12. Table 1. 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.766 business units.1 30.8 12. II companies consistently declined over time. In 1997. a Value added was assumed to be 30 percent of total sales.7).1 6.5 Conglomerates This study used available data on the top 300 conglomerates in Indonesia.6 percent in 1994. a Value added was assumed to be 30 percent of total sales.1 310. Their total sales increased from Rp90.2 — 370. 1992 — 7.7 16.2 23.8 percent in 1990 to 13.4 7.8 21.4 13. Assuming a constant ratio of value added to sales.6 28.0 6.3 250.1 32.5 percent in 1995. but climbed to 30. these conglomerates owned 9. but dropped to 11.1 19.0 24.1 trillion in 1990 to Rp234 trillion in 1997. Source: Indonesian Data Business Center.4 16.0 7.7 Growth Performance of the Top 300 Conglomerates.0 28.0 12.6 28. Vol. .7 13.7 1994 (9.0 8.6 1995 25.4 13.8 11.0 17.4 percent in 1992 to 28.2 percent in 1997 (Table 1.4 percent in 1994. SOCs’ asset turnover rates showed a downward trend from 32. b Asset turnover is defined as sales over assets.1) 5.0 8.4 1993 16. the contribution of conglomerates to GDP increased from 12.2 18.6) 260. mostly private companies.1 12.7 (2. Source: Indonesian Data Business Center.5 3.
The meeting decides on important issues. By international standards. and consolidations. and the attendance should at least be two thirds of total shareholders. The BOC. This guards against shady intercompany dealings within a group of companies. The law replaced an earlier statute that was based on the Dutch system. For instance. except in strategic issues stated in the law.6 Legal and Regulatory Framework During the 1990s. A chairman heads the BOC while a chief executive officer (CEO) heads the BOD. For instance. The BOD undertakes operating decisions while the BOC participates in strategic decisions and operations review. The law also specifies that the highest “institution” in the limited company is the shareholders’ meeting. such as the appointment (or replacement) of directors. In general. The Corporate Law The Corporate Law of 1995 governs the establishment and operation of limited liability companies in Indonesia. and the board of directors (BOD). a member company might sign a disadvantageous contract with another company where the same controlling shareholder has a higher stake. an approval needs the majority (50 percent plus one) vote. For example. is the only shareholder mechanism for monitoring and controlling the BOD. tasked with supervising the firm. tasked to provide direction to the company. The company charter details the issues that need shareholder meeting approval.Chapter 1: Indonesia 15 1. mergers. the Government promulgated a number of laws and regulations to protect investors.2. acquisitions. shareholders lose control. The actual responsibilities of BOCs vary by company and are stipulated in the company’s charter. and the accountant. The law explicitly requires approval during the meeting of decisions on strategic issues such as amendment of the company charter (articles of incorporation). the legal and regulatory framework of the corporate sector was far from adequate. as representative of shareholders. the decision to amend the company charter should be approved by two thirds of shareholders present in the meeting. The law also holds the directors and commissioners jointly responsible for decisions made by the company. The law mandates the BOC and BOD to work for the best interests of the company and not just of the shareholders. For mergers. If the BOC does not perform well. and declaration of bankruptcy. however. The 1995 law requires limited liability companies to set up two boards: the board of commissioners (BOC). commissioners. . the decision to use certain company assets as collateral for bank credit might need BOC approval.
(xiv) mandatory disclosure of intercompany affiliation such as affiliated lending or guarantees. An important rule is the requirement for independent shareholders’ approval for arrangements that might lead to conflicts of interest. decrees of the finance minister. (iii) proxy voting by mail. underwriters. transparency requirements. The law is supplemented by Government regulations. (viii) the right to make proposals at the shareholders’ meeting. investment advisors. It also regulates reporting and auditing procedures. the decision should be approved by three fourths of the shareholders present. The Capital Market Law The Capital Market Law (1995) regulates companies listed in the stock exchange. Because of such requirements. (xii) mandatory disclosure of connected interests. (ix) mandatory shareholders’ approval of interested transactions. Examples in the area of corporate governance are guidelines for situations that can potentially lead to conflicts of interest and for acquisitions of substantial shares of listed companies. and administrative and legal punishment. and bankruptcy. (vi) one share one vote. . (xiii) mandatory disclosure of nonfinancial information. (xi) mandatory disclosure of transactions by significant shareholders. II acquisitions. Vol. The law provides the following rights to or protection of shareholders: (i) access to regular and reliable information free of charge. (xvi) independence of auditing. and the attendance should at least be three fourths of total shareholders. (x) mandatory shareholders’ approval of major transactions.16 Corporate Governance and Finance in East Asia. and other supporting agencies. (xvii) mandatory independent board committee. securities companies. consolidations. 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. (iv) cumulative voting for directors. It regulates the requirements of investment companies. (xv) mechanisms to resolve disputes between the company and shareholders. Controlling shareholders have no vote on the matter. delineating the tasks and responsibilities of the Capital Market Supervisory Agency. insider trading (including market rigging and manipulation) investigation. (v) preemptive rights on new share issues. A tender offer is also required for acquisitions of up to 20 percent of listed shares. and (xviii) severe penalties for insider trading. (ii) proxy voting. investment managers. (vii) the right to call an emergency shareholders’ meeting. brokers. and guidelines promulgated by the head of capital market supervision. such as custodian banks and the securities registration bureau.
states that a bank is not allowed to provide credit without collateral. or financial institutions. the collateral could take the form of nonphysical assets (e. capital adequacy..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. for instance.g. Banking regulations also set lending limits. Unsecured creditors could proceed against a debtor in default based on loan covenants and through the legal process of collection against the latter’s assets. five. A new bankruptcy law was passed in August 1998. . the viability of a project).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. families. Ownership concentration is usually measured by the proportion of shares owned by the top one.3. For instance. The court can declare the debtor bankrupt upon the request of at least two creditors and default on one loan. 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. A Commercial Court was also set up to deal with bankruptcy cases. Discussions on corporate ownership cover listed companies and conglomerates. the Banking Law (1992).Chapter 1: Indonesia 17 Bankruptcy Law Despite loan covenants. However. amended in October 1998. holding companies. creditors of unsecured loans are unprotected when borrowers fail to meet their obligations. It reveals characteristics of controlling shareholders. net open positions. etc. or 20 shareholders. whether they are individuals. 1. Banking Laws Affecting the Corporate Sector Some elements of the banking law also affect the corporate sector.
and 0.5 percent.0 67. 2.3 1995 47. This is partly due to the prevailing practice of raising equity through rights issues in Indonesia.5 1997 48.6 4.6.2 67. 3.5 Average 48.0 0.6 13. Zebra Nusantara (taxi services). the five largest shareholders owned 68.9. the controlling shareholders usually act as standby buyers. issued 93.6 68. On average.5 16. When a company makes a rights issue. Rig Tenders Indonesia (shipping services) issued 51.7 1994 48. the founder usually continues to own the majority of shares through a .9 2.8.6 3.5 72. for instance.9 Source: The Indonesian Capital Market Directory. respectively.7 3.1 1. When a company goes public. about two thirds of publicly listed companies’ outstanding shares were owned by corporations that were directly or indirectly controlled by families. This is because a few companies in the transportation sector issued high proportions of shares to the public. 1993-1997 (percent) Shareholder Rank First Largest Second Largest Third Largest Fourth Largest Fifth Largest Total 1993 50. Table 1.1 0.9 shows that ownership by the largest shareholder in 1997 was more concentrated in the agriculture.8 shows average proportions of shares owned by the five largest shareholders of publicly listed companies during 1993-1997.0 2. consumer goods.6 3.9 0.0 4. The percentage owned by each of the five largest shareholders was 48. ownership widely held by the general public is highest in the infrastructure and transportation sector (not shown in the table).9 14. and basic industry and chemicals sectors than in others.8 68.0 1.8 Ownership Concentration of Publicly Listed Companies.2 11.1 4.1 13.8 1.0 0.4 2.9 percent of total outstanding shares. II Publicly Listed Companies Table 1.2 1. and Berlian Laju Tankers (liquid bulk maritime transportation services) issued 48.5 12.8 68. Table 1.18 Corporate Governance and Finance in East Asia. mining. Vol.7 1996 48. The pattern of ownership concentration changed little over this period. Data from the Indonesian Capital Market Directory (various publications) show that between 1993 and 1997.6. 13. Meanwhile. This preserves the pro rata share of existing shareholders.6 percent.9 2.4 percent.
two thirds (67.1 2.6 1.Chapter 1: Indonesia 19 fully-owned limited liability company (Perseroan Terbatas).6 percent were widely held.1 0. and Bldg. which shows that in 1996.1 1.7 4. as well as the existence of corruption.3 14.6 8.1 13. and the efficiency of the judicial system.1 2.1 11. and Services Average Source: The Indonesian Capital Market Directory. Util.3 0.9 50. Infrastructure. Claessens et al. in a cross-country study.6 0.7 1.7 percent of the market.2 46. These figures suggest that ultimate control of the corporate sector rests in the hands of a small number of families.9 0.1 0.6 percent of total market capitalization while the top 15 families control 61. (1999) also found.4 44. and only 0. Most of the five largest owners of Indonesian publicly listed companies are limited liability companies rather than individuals..9 3.1 1.3 0.5 1. that the correlation between the share of the largest 15 families in total market capitalization. the rule of law.4 4. The findings suggest that the concentration of corporate control in the hands of few families is a major determinant of the evolution of an inefficient legal and judicial system.9 1.7 9.9 Ownership Concentration of Publicly Listed Companies by Sector. (1999). the top family controls 16. Real Estate. Indonesia has the largest number of companies controlled by a single family.8 14..6 2. First Second Third Fourth Fifth Biggest Biggest Biggest Biggest Biggest 54.7 6.5 4. on the one hand. Table 1.3 48.3 36.6 9. is strong.7 13.1 2.4 11.9 44. Thus the founder keeps the proportion of shares necessary to retain control over management of the listed firm.3 2. and Transportation Finance Trade.1 1. and corruption.1 percent) of Indonesian publicly listed companies were in family hands. on the other. Constn.2 0.2 2.2 10.5 58.2 This is confirmed in Claessens et al.4 1. Legal and regulatory developments may have been impeded by the concentration of corporate wealth in . Industry Consumer Goods Industry Prop. In fact.1 1. Investment.4 6. 1997 (percent) Sector Agriculture Mining Basic Industry and Chemicals Misc.4 54.9 44.0 5.2 15. In terms of capitalization.
numbering 162 in 1988 and 170 in 1996. the onset of the crisis negated this development. the proportion of foreign ownership declined from 27. However. Family control is said to have positive effects in that it allows group members in conglomerates to make strategic decisions quicker. From 193 in 1988. II the small number of families and the tight links between companies and the Government. or other ethnic groups.42 percent in December. foreign ownership increased to 21 percent.5 Conglomerates Table 1. Sundanese. In 1993. Indian. 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. resulting instead in a decline in the proportion of foreign investor ownership. Coordination is easier because informal communication channels exist. and family origin. Batak. However.10 shows the anatomy of the top 300 conglomerates in terms of year of establishment. Among the top 300 conglomerates. the legal system is less likely to evolve in a manner that protects minority shareholders. In September 1997.20 Corporate Governance and Finance in East Asia. there is a dichotomy between corporations owned by indigenous and nonindigenous businesspeople. During 1988-1996. was able to create a favorable environment for business development. The corruption and regulatory problems generated by high ownership concentration by families in Indonesia are likely to overwhelm its benefits. This may indicate that the New Order Government. and Padang. nonindigenous groups owned a larger proportion of the top 300 Indonesian conglomerates. political affiliation. conglomerates established before 1969 dominated in terms of sales. Indigenous businesspeople include the Javanese. Vol. but later declined and steadied at around 25 percent. . In Indonesia.55 percent in August to 25. ethnicity. their number increased to 5 In 1997. it rose to 30 percent. with all its regulations. The nonindigenous businesspeople are usually Chinese. When the Government allowed foreign investors to buy up to 49 percent of listed shares in 1988. But these benefits are few and often dubious compared to the high costs of concentration. the Government allowed foreign investors to buy up to 100 percent of listed shares. accounting for 64 percent of total conglomerate sales in 1988-1996. most were established during the New Order Government.
Their total sales also increased from Rp38.6 trillion in 1988 to Rp137.0 44.9 73.8 12.4 57.3 36.4 37. due to their “go public” activities.8 25.6 17.3 134.1 46.3 20.8 68.9 47.4 16.8 28.1 46.8 38.2 23.5 120.8 Source: Indonesian Business Data Centre.9 137.4 22.6 114.2 33.9 42.1 42.7 64.9 35.4 31.4 trillion in 1996.1 25.3 120.0 116. For instance.7 40.10 Anatomy of the Top 300 Indonesian Conglomerates.8 57.1 41.2 48.7 106.0 58.9 13.5 106.5 22.4 69.8 49.6 95.4 31.5 21.1 179.2 29. the number of mixed groups declined from 86 in 1988 to 68 in 1996. Conglomeration Indonesia 1997.6 77.0 28.8 30.4 19.7 28.1 21. more than five times its 1988 level. While they supplied 20.0 15.2 76.4 59.1 33.3 80. In 1996. 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 9.7 24.4 52.1 87.7 49.2 159.1 103.7 95.2 30.4 86.7 89.0 18.6 34.4 18.1 52.4 48.6 12. sales of the Bakrie group before it went public in 1990 were only Rp369.9 trillion.9 77. 204 in 1996.4 68.0 58. Meanwhile.3 43.9 billion.4 32.3 101.8 36.0 31.2 12.9 14.4 59.4 15.Chapter 1: Indonesia 21 Table 1.4 81.1 percent of total .6 54. its sales reached Rp1.1 58.
their contribution declined to 13. which is the largest conglomerate in Indonesia. But listed companies within conglomerates were few.and officialrelated groups. 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. Out of 174 companies. owns four groups with many subsidiaries and affiliate companies. The high NPLs accumulated by banks within official-related groups could be partly attributed to this practice. Indocement Tunggal Prakarsa (cement industry). or have resulted from alliances between entrepreneurs and officials. In 1997 and 1998. Official-related groups have owners (or founders) who are or are allied with former or current government officials (or their families). and Wisnu Suhardhono of Apac-Bhakti Karya. average sales of official-related conglomerates reached Rp1.2 trillion. In 1996. collectively controlling . Prudential credit analysis tends to be ignored. most of the 16 liquidated banks had violated the legal lending limit set by the central bank. Bambang Rijadi Soegomo. and Ibrahim Risyad of the Salim group. Conglomerates were also classified into nonofficial.7 percent in 1996. But only a handful of these companies are listed in the market. compared with the less than Rp700 billion of a nonofficial-related conglomerate. Political alliances between entrepreneurs and officials have often led to the violation of regulations meant to promote prudent business practices in the banking industry. The Salim group. 117 are jointly owned by the family and 57 are owned by individual family members. and Fast Food (restaurants). The Suharto family is the largest stockholder in Indonesia. Djuhar Soetanto. including Indofood Sukses Makmur (food industry). II sales in 1988. Only about 13 percent were formed by official or ex-official families. The well-known official-business alliances are those between Sudwikatmono (former President Suharto’s cousin) and Soedono Salim. Bank Indonesia. Some of them later became public companies by listing in the stock market. More recent alliances were between Bambang Trihatmodjo (former President Suharto’s son) and Johannes Kotjo. In 1996. Most of the top 300 conglomerates were established by ordinary citizens. Banks owned by groups or conglomerates typically act as a “cashier” that provides credit to companies within the group. for instance. Average sales of official-related conglomerates were substantially greater than nonoffficial-related ones during 1988-1996. Vol. The contraction in the number and economic contribution of mixed groups may be an indication of increasing social polarization along ethnic lines.22 Corporate Governance and Finance in East Asia. In November 1997.
Cross-holdings between financial and nonfinancial firms potentially create more serious problems. Indonesian law allows cross-shareholdings. Some of the groups related to officials have a unique share ownership structure. management. But it is difficult to obtain data on cross-shareholding among firms. the controlling shareholders are able to maintain their special relationship with officials. besides Suharto himself.Chapter 1: Indonesia 23 assets worth $24 billion (Claessens et al.. Cross-Shareholdings Cross-shareholding is one way to enhance corporate control and occurs when a company down the chain of control has some shares in another company within the same chain. Although they are not actively involved in the daily operations of the companies.1). many of whom. Cases in point are the Bank Papan Sejahtera and Bank Niaga. It is generally believed that there are cross-holdings between financial and nonfinancial companies and among nonfinancial firms. He or she could either be the biggest shareholder. Indofood Sukses Makmur (food industry) was owned by Indocement Tunggal Prakarsa (cement industry). If the family members cannot actively manage the companies as directors. they still control the work of the directors. The family controls 417 listed and unlisted companies through a number of business groups led by the Suharto children. with no restrictions. While the source of the . The Salim Group is also in part controlled by the Suharto family. In so doing. families mostly manage the groups and make strategic decisions themselves. for instance. as well as other relatives and business partners. or someone very close to and trusted by the controlling shareholders. Semen Cibinong. or both. they maintain their position as commissioners. continue receiving some kind of protection and special treatment. This is because cross-owned banks had to consider not only their own interests. The officials (or their family members) often own a small portion of shares given to them freely by controlling shareholders. The BOC chairperson often represents the controlling party of the company. and hence. 1999). Although some groups employ professional managers. which were liquidated or recapitalized after being acquired by the Tirtamas group that owns a listed cement company. but those of the entire group. served in some government function (see Figure 1. Both are listed companies and members of the Salim group. In 1996. The families retain control of the companies through ownership.
Lang. Who Controls East Asian Corporations? Financial Economics Unit. 1999). and Larry H. World Bank.1 The Suharto Group Usaha Mulia Group (cousin Hasim) Cemen Cibinong Hanurata Group Suharto Family Citra Lamoro Group (daughter Mbak Tutut) Bank Yama Bob Hasan Group (Mohamad Hasan) Gatari 22 firms with control over 20% Citra Marga Persda Tollroad Trias Sentosa Bank Central Indomobil Mercu Buana Group (step brother Probo) 11 firms with control over 20% Kedaung Indah 14 firms with control over 20% Kedaung Group (Agus Nursalim) 18 firms with control over 20% Tirtamas 21 firms with control over 20% 262 firms with control over 20% Salim Group (friend Soedono) Sempati Air Humpuss Group Bank Utamar 17 firms with control over 20% Bimantara Group (son Bambang) TPI Andromed Tripolita 8 firms with control over 20% Kabelindro Kiani Murmi Sakti Source: Stijn Claessens. Financial Sector Practice Department. P. . Simeon Djankov.Figure 1. (Feb.
and accounting and auditing procedures. both controlling and minority. management and managerial compensation. one possibility is that legal lending limits had been violated. 1. As the owners’ representatives. Figure 1. role and protection of minority shareholders. .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. seek an audience with directors. including the boards. the BOC has the right to obtain any information concerning the firm. The managers execute the BOD’s decisions and lead employees in their departments. if necessary. the directors. request a shareholders’ meeting. This is based on the Dutch system.3. the BOC supervises the work of directors. and. The discussions are based on the ADB survey of 40 companies listed in the Jakarta Stock Exchange. The typical structure of a publicly listed company in Indonesia is shown in Figure 1. The BOD leads the company and makes strategic and operational decisions.Chapter 1: Indonesia 25 problem is inconclusive. Shareholders are at the top of the organization. Therefore.2.2 Management and Internal Control A company’s internal organizational structure determines how shareholders control management.
Corporate Governance and Finance in East Asia, Vol. II
Board of Commissioners and Board of Directors Table 1.11 presents a summary of some characteristics of the BOC. The table reveals that 29 out of 40 companies surveyed did not have independent commissioners. Although 23 companies reported that commissioners were elected based on professional expertise, nine companies reported that selection was based on relationships with controlling shareholders, and another nine reported that commissioners were the company’s founders. Table 1.11 Characteristics of the Board of Commissioners
Number of Firms Responded 11 29 23 9 9 10 22 7 27 7 8 8 30 6 4
Questions Presence of Independent Commissioners a. Yes b. No Basis for Electing the Board of Commissioners a. Professional expertise b. Relationship with controlling shareholders c. As founders of the company Procedure in Electing the Board of Commissioners a. Nominated by the management and confirmed by the AGM b. Nominated by significant shareholders and confirmed by the AGM c. Nominated and elected by shareholders during the AGM Basis for Electing the Chairman of BOC a. Professional expertise b. Shareholdings c. As founders of the company d. Relationship with controlling shareholders Relationship between the Chairman and CEO a. Not related by blood or marriage b. Related by blood or marriage c. No answer
Note: Since companies could answer more than one alternative, the total does not necessarily add up to 40 for each question. Source: ADB Survey.
In most companies (22 out of 40), members of the BOC were nominated by significant shareholders and confirmed at the annual general meetings (AGMs). A nominee that was not supported by significant shareholders
Chapter 1: Indonesia
was unlikely to be chosen as a commissioner. Most companies (27 out of 40) elected their BOC chairman based on professional expertise. The majority of firms (30 out of 40) also reported no relationship between the chairman and CEO either by blood or marriage. A similar picture is obtained for the BOD (Table 1.12). Most companies (30 out of 40) reported not having independent directors. Professional expertise was an important basis in electing directors for 29 companies. Relationships with controlling shareholders and founders of the company were the basis for selecting directors in 11 companies. Table 1.12 Characteristics of the Board of Directors
Number of Firms Responded 10 30 29 7 4 13 22 6 29 3 7 8
Questions Presence of Independent Directors a. Yes b. No Basis in Electing Board of Directors a. Professional expertise b. Relationship with controlling shareholders c. As founders Procedure in Electing Board of Directors a. Nominated by the management and confirmed by the AGM b. Nominated by significant shareholders and confirmed by the AGM c. Nominated and elected by shareholders during the AGM Basis in Electing the Chief Executive Officer a. Professional expertise b. Shareholdings c. As founders of the company d. Relationship with controlling shareholders
Note: Since companies could answer more than one alternative, the total does not necessarily add up to 40 for each question. Source: ADB Survey.
Twenty-two out of the 40 respondents elected their directors through nomination by significant shareholders and confirmation by the AGM. Most companies (29 out of 40) selected the CEO based on professional expertise, although some companies based it on relationships with controlling shareholders.
Corporate Governance and Finance in East Asia, Vol. II
Management and Managerial Compensation The Corporate Law mandates the BOD to lead the company and make strategic and operational decisions, and the BOC to supervise the work of the directors. The BOC also reviews the results of operations and participates in strategic decision making. This indicates some overlapping functions for the BOC and the BOD, which is confirmed in the ADB survey. This overlapping of responsibilities, particularly in making strategic decisions, may result in conflicts. However, since the BOC appoints members of the BOD and determines their remuneration, the BOC is in a strong position to dominate the BOD. Twenty-five out of 40 firms indicated that the CEO makes important decisions after consulting the chairman of the BOC. In carrying out their tasks, the majority of firms reported not having committees to assist the BOD and BOC, as shown in Table 1.13. Only a few companies have nomination, remuneration, and auditing committees, most of which were set up between 1995 and 1997. In 1995, Bank Indonesia required commercial banks to have an auditing committee. Table 1.13 Presence of Board Committees in Listed Companies
Type of Committee Nomination Committee Remuneration Committee Auditing Committee None Total
Source: ADB Survey.
BOD 5 5 5 23 38
BOC 1 1 3 35 40
Most firms reported terms of appointment of three to five years for the BOD and BOC. In some companies, the term differs for commissioners and directors. Although the term is for three to five years, in 13 out of 40 companies, the directors and commissioners have been in service for more than five years. Results of the ADB survey show that in 18 companies, the CEO is given fixed compensation plus a profit-related bonus. In 14 companies, only fixed compensation is given. For the BOC chairman, 10 companies
Chapter 1: Indonesia
provide fixed compensation plus profit related bonus, while 14 companies provide fixed compensation only. Role and Protection of Minority Shareholders Indonesian law requires publicly listed companies to have at least 300 shareholders to help ensure share liquidity and dispersed ownership. The highest number of shareholders is found in Bank BNI (a state-owned bank), reportedly having 27,568 shareholders. Small companies simply comply with the minimum shareholder number requirement. Most companies reported that their shareholders enjoy all mandated rights and protection, except those on proxy voting by mail, cumulative voting for directors, and the independent board committee. A company charter (articles of incorporation) stipulates the quorum requirement during annual meetings, which is usually two thirds of total shareholders. The ADB survey showed that more than 67 percent of shareholders attended the last annual meeting in most companies. While proxy voting is allowed, proxy votes accounted for less than 10 percent of shareholders on average. Brokerage companies and management were the usual proxies. A change in the company charter requires a two-thirds majority vote by shareholders. The ADB survey revealed that in the last three years, only one management proposal (i.e., director’s fee) was rejected during the AGM. This is not surprising because management usually seeks prior approval of proposals from controlling shareholders. Accounting and Auditing Procedures Thirty-five out of 40 respondents in the ADB survey claimed to have substantially followed international accounting standards even prior to the financial crisis. Accounting authorities, however, can easily change acceptable accounting methods. After the crisis, for instance, the Indonesian Accountants Association recommended that potential foreign exchange losses be reported as losses at the end of the accounting year. Later, the association allowed companies to choose between declaring it in the profit and loss statement at the end of the accounting year or in the balance sheet. All companies in the survey reported the presence of an independent auditor, which is usually an international audit company. Most companies have been associated with their independent auditors for more than five years. Shareholders appoint the external auditor during the AGM.
Corporate Governance and Finance in East Asia, Vol. II
Control by Creditors The control of creditors over a debtor company rests on assets used as collateral for loans. Unsecured creditors resort to the legal process when problems arise. Based on the ADB survey, each company was associated with an average of five creditors, the majority of which were banks. Some companies were associated with an excessively large number of creditors, reaching up to 30. Most of the companies have been dealing with their institutional creditors for less than three years. Although the banking law requires collateral for bank loans, some creditors did not enforce the requirement. Only 10 companies reported that they were required to provide collateral by all creditors. Twelve companies claimed having creditors that did not ask for collateral. Twenty-five out of 32 companies reported having renegotiated loans with creditors in the last five years, mostly after the Asian crisis. This indicates that many companies experienced serious difficulties in repaying debts as a result of the crisis. But most of these companies stated they would possibly borrow from the same creditors, indicating their relatively strong bargaining position. The majority of firms (22 out of 29) also said that creditors had no influence in management decision making. In 1998, the Bankruptcy Law was passed to protect creditors and the Commercial Court was set up to deal with bankruptcies. This paved the way for unsecured creditors to proceed against a debtor in default based on loan covenants and through the legal process of collection against the debtor’s assets. However, enforcement of the law was a disappointment to those who hoped that it would put corporate restructuring and the settlement of corporate debts on a running start. Only 17 cases had been filed with the court by late November 1998. Just two companies had been declared bankrupt, and three suits were dismissed by the Commercial Court. The Government’s political will and support are still very much needed in order to set up a well functioning Commercial Court. Long and hard work is required to restore creditors’ confidence in Indonesia’s legal system. The Market for Corporate Control Between 1992 and 1997, there were 40 cases of acquisition and takeover of Indonesian companies. Most of these, however, were internal acquisitions (i.e., acquisition of a company in the same group). Only five cases were
Before the financial crisis. 6 7 Later in March 1999. Bank Niaga was under a recapitalization program. In these two latter cases. This used to be a common practice in companies associated with the Suharto regime. the acquiring interest was apparently seeking economic profits. . The Government is thus able to appoint some officials to be members of the private firm’s BOD or BOC. it was common for the Government to invest in certain private companies. the acquiring parties were trying to obtain operating synergies because they had companies in the same industry. at a large profit. Another case was the takeover of Bank Niaga in 1997 by Djojohadikusumo. One famous takeover was Bank Papan Sejahtera. They then replaced the BOD and later sold the bank. In April 1999. appointment of management. The BOD and BOC of PT Sari Husada were allowed to complete their terms before they were replaced. A study by Connie Tjandra (1993) shows that internal acquisitions were often initiated for tax shelter purposes. However. Wijaya and his friends bought shares of the bank on several occasions until they gained control. to Hashim Djojohadikusumo. a state-owned insurance company may invest its funds in a private firm. IBRA found itself tasked with managing large amounts of assets in the private sector. Since the NPLs reached up to Rp300 trillion.Chapter 1: Indonesia 31 external acquisitions. In the massive restructuring of the banking sector that commenced after the crisis. Most Indonesian state companies are 100 percent owned by the Government. The Government appoints the BOD and BOC of these firms. The bank was reported to have high NPLs and had broken the legal lending limit. or direct subsidies.6 In this case. which was acquired by Yopie Wijaya in 1995. with the minister’s approval. the bank was liquidated. the takeover brought significant losses to Djojohadikusumo when share prices plunged7 during the crisis. Control by the Government Government control could be in the form of state ownership. restrictions on market entry. who was acquiring his second commercial bank. A more recent case was the acquisition by Nutricia (the fourth largest baby food firm in the world) of PT Sari Husada (another baby food firm) in 1998. State ownership for listed SOCs ranges from 25 to 35 percent. except for publicly listed SOCs. For instance. the Government took over NPLs and put them under IBRA management. the owner of Tirtamas group.
because of the restrictions discussed below.6 percent in 1997.5 7. private national banks overtook state banks as the dominant credit source.14 Banking Sector Outstanding Loans.2 71.4 percent in 1992.6 292. stocks.9 153.0 3.4. Bank Credit As shown in Table 1. and others offered by nonbank financial institutions or finance companies.6 48.4 225.3 188. the share of private national banks in outstanding total loans increased to 44.8 193. From 34.0 487. companies considered alternatives to bank loans.2 6. When the Government liberalized the banking industry at the end of 1988 (which allowed for higher interest rates).3 111.9 234.7 18.1 Equities In 1977. II 1.5 80.0 6.0 168.3 66. Since then. Data from Bank Indonesia show that from 1994 to 1997.9 378.4 trillion in 1998. remain the major financing instrument for the corporate sector.2 27.3 9.4 56. bank credit surged from Rp122.6 150. Private national banks and state-owned banks were the biggest domestic creditors.6 6. new instruments have been introduced to the corporate sector. however. However. jointly providing almost 90 percent of loans until 1997.9 trillion in 1992 to Rp487.3 60.7 122. 1992-1999 (Rp trillion) Type of Bank State-Owned Banks Foreign Banks Regional Govt Banks Private National Banks Total Source: Bank Indonesia.1 Corporate Financing Financial Market Instruments Prior to 1977.2 5. when the Government reactivated the stock exchange. Vol.6 4.7 112.5 108.5 42.3 14.4 1.32 Corporate Governance and Finance in East Asia.7 50. Table 1. equities became available to the corporate sector. this market was not well developed.0 93.9 150. bank loans were the only instruments available to the corporate sector for short term (working capital) or long term (investment) financing. Bank loans.1 220.14.6 3. including bonds. 1992 1993 1994 1995 1996 1997 1998 1999 68.4 24.4 86. .
thus increasing the role of the capital market in raising long-term funds.0 15. and net open position).2 16..g. In 1995. the stock market has gained a bigger role in corporate sector financing (Table 1.Chapter 1: Indonesia 33 Some companies went public. but dropped to 8 percent in 1991 when the Government tried to stabilize an overheating economy.7 15.8 48. when foreign investors were not yet allowed to purchase listed shares. legal lending limit.1 18.4 207. factoring..e.0 206. credit cards. During the 1990s. They were not.6 859. shooting up to 18. It gradually increased again starting in 1991. funds raised in the stock market were less than 5 percent of the credit disbursed by the banking sector.4 1996 1997 1998 50. offering services such as leasing.9 406.7 14.3 percent in 1990 when the stock market was liberalized and foreign investors were allowed to purchase up to 49 percent of listed firms’ shares. and consumer credit.7 9. Most banks therefore set up subsidiary finance companies to circumvent banking regulations. 1992-1999 (Rp trillion) Item Stocks Issued Outstanding (As % of Outstanding Bank Credit) Market Capitalization Source: Bank Indonesia. limiting loans to a maximum of 15 times equity and foreign loans to five times the equity. Prior to 1995.5 333. i. 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 1996.0 70. however.1 10. the Government issued regulations to supervise and promote prudential practices in finance companies. Overall. In 1988.1 1994 26.9 1999 76. 1992 1993 11.6 91. allowed to accept deposit accounts from the public.6 310. the activities of finance companies were not covered by regulations on prudential practices in the banking sector (e.1 17.15 Value of Stocks Issued and Stock Market Capitalization.5 Financing by Finance Companies Finance companies first emerged at the end of 1980. finance companies were increasingly used as channels for the inflow of foreign loans. .6 301. capital adequacy ratio.7 percent in 1997.6 123.5 1995 35.15). The ratio reached 8. Table 1.
16 Financing Patterns of Publicly Listed Nonfinancial Companies.0 39. 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). 1986-1996 (percent) Financing Source Internal Borrowings Short-Term Long-Term Debentures/Equity Debentures Equity Trade Credit Others Total 1986-1990 36. respectively.5 percent and 36.0 3. at 81 percent of total borrowings. Source: Author’s estimates based on the Pacific-Basin Capital Markets (PACAP) Databases. they were not rated by a rating agency. which are unsecured negotiable promissory notes with a maximum maturity of 270 days.4.0 1991-1996 16. In terms of composition. 1.5 (0.1) 23.7 22.0 100.34 Corporate Governance and Finance in East Asia. II Commercial Papers Commercial papers. . otherwise it would be classified as a loss in the banks’ books.1) 23.8 17. Bank Indonesia prohibited banks from underwriting issues of commercial papers but allowed them to act as paying agents.6 100.2 26. PACAP Research Center.5 11.6 100. publicly listed nonfinancial companies had high proportions of equity and internal finance (retained earnings).0 1986-1996 17.4 13. While banks had some exposure to these instruments.4 8.3 37.9 16. short-term borrowings were greater than long-term debts.5 — 26.6 23. averaging 26. In the second half of the 1980s.16 shows financing sources of Indonesian publicly listed nonfinancial companies estimated by using flow-of-funds analysis. Thus in November 1995. Vol.5 21.8 7. have been popular in Indonesia since 1990.3 (0.3 14.0 — = not available. 1996.3 16.6 12. This is in contrast to the lower share of borrowings during the same period.8 percent.6 8. Table 1.4 23.2 Patterns of Corporate Financing Table 1.
They also do not want to dilute corporate control and are more likely to finance growth with debt. which managed to post significant profits due to low exposure to dollar-denominated loans.6 trillion and Rp1. These liabilities grew significantly because corporate expansion was largely financed by debt. Indofood registered losses of almost Rp1.9 trillion in 1996. respectively. This amount doubled in 1997. The high share of equity financing was due to the surge in capital market activity following the 1988 reforms.1 trillion. 1. Indosat and Telekom. Two telecommunications companies.9 trillion.2 trillion. which was masked by the rapid growth in investments. Large shareholders are inclined to undertake risky projects intended to generate high returns using borrowed funds. reaching Rp229. corporate debts accounted for 39. with longterm debts increasing rapidly. Note that the corporate sector’s high leverage existed side by side with sizable equity capital raised from the capital market. All companies in the cement industry suffered from foreign exchange losses. The results indicate that firms with higher ownership concentration tend to have a higher DER. the pattern changed.4 trillion in 1993 to Rp112. Many companies suffered big losses in 1997 due to their high exposure to dollar loans.2 trillion (mostly foreign exchange losses). except Semen Gresik (an SOC). also suffered from foreign exchange losses but managed to post profits of Rp0. that ownership concentration may be associated with heightened risk-taking by companies. the corporate sector’s high leverage. Hence. Table 1. For instance. . rising from Rp54. as evidenced by an average DER of 230 percent during 1992-1996 that rose to 310 percent in 1997. Corporate debts grew over time. The corporate sector invested heavily from 1991 to 1993 and slowed down its investment spending a few years before the 1997 crisis.17 compares the DER of listed firms by degree of ownership concentration. Most corporate charters require commissioners to approve debt issues or sign debt agreements. in the context of Indonesia and some other countries. while Semen Cibinong’s losses reached Rp2.Chapter 1: Indonesia 35 In the 1990s.3 percent during 1991-1996.3 Corporate Financing and Ownership Concentration It has been suggested. 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.4. Of the various financing sources. was due largely to a rapid rise in long-term debts. Bank loans also surged when the banking sector was liberalized in 1988.
17 DER of Listed Companies by Degree of Ownership Concentration (percent) Item Mean Standard Deviation DER of Firms with High DER of Firms with Low Ownership Concentration Ownership Concentration 699.0 1. The low cost of foreign loans and the relatively stable exchange rate created a false sense of security for corporations. ultimately. Controlling parties rely on external financing to maintain their equity share and.5.56 significant at the 10 percent level. the borrowings swelled.0 351. aided .1 The Corporate Sector in the Financial Crisis Causes of the Financial Crisis Many intertwined factors led to the crisis. In addition. to maintain control of the company. Table 1. the free capital flow system allowed private companies to borrow dollars offshore without any restriction.0 386. Source: Author’s estimates. Inadequate Financial Regulatory Framework Liberalization of financial markets increased the corporate sector’s access to domestic and foreign private capital. and high ownership concentration among families with political affiliation. The test of the difference between the two means found the t-value of 1. since commissioners represent the controlling party. decisions on debt are made with the implicit endorsement of owners. 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. Vol. 1. As a result.5 1. heavy reliance of companies on bank credits to finance investments. Between 1987 and 1996.36 Corporate Governance and Finance in East Asia.358.0 Notes: Firms with high ownership concentration have more than 50 percent of shares owned by the top five shareholders. the private sector borrowed heavily in unhedged dollars. II However. 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.
Chapter 1: Indonesia 37 by the lack of an existing mechanism to supervise and monitor foreign transactions.. In the process. 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. A director at Bank Indonesia revealed that in 1995. It also meant that the cashier bank had neither the independence nor the incentive to exercise ex ante and ad interim monitoring of borrowers. 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. only created to serve the companies to which they lent. the level of corporations’ foreign debt could not even be ascertained. conglomerates set up finance companies and used these as channels for the unfettered inflow of foreign loans in lieu of banks. after all. averaging about 4 percent of GDP. A lot of short-term foreign funds were used to finance long-term investment projects. However. many firms became highly leveraged. to circumvent these banking regulations. 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. and the negative net open position (short position in dollars) continuously rose to precarious levels. large amounts of credit were directed to the companies within the group. This left them vulnerable to interest rate surges as well as sudden currency fluctuations in the case of dollar loans. However. It was only in 1995 that some regulations on the activities of finance companies were contemplated. The Government later specified the legal lending limit and the net open position that banks had to follow. did finance many viable ventures. The supervising agency was caught unprepared. It was doubly difficult to exercise supervision when groups with political clout owned the banks. As a result. Decisions to borrow in dollars made sense to many borrowers because dollar loans were cheaper than rupiah loans. The banks served as a “cashier” that provided easy credit to nonfinancial companies within the group. The large supply of foreign funds. This often led to the violation of prudential credit management practices. It is not known if these regulations had an effect on nonbank intermediaries. substantial amounts were also funneled into projects that guaranteed repayment mainly on the strength of borrowers’ close political connections. .e. Conglomerates that had difficulty in getting loans (i. They were. those with high DERs) established their own banks.
Controlling shareholders also prefer to use debts to finance expansion so as not to dilute their ownership. of which $64. as they had done so in the years before the crisis. total private sector foreign debt stood at $72. partly because they used nominee accounts to register ownership rather than set up a holding company. $35 billion of Indonesia’s foreign debt owed to private foreign banks was about to mature in less than one year. Since the Government could not afford to undertake these projects. Aside from the fact that many of these loans were channeled through banks and corporations of politically connected families. where private banks are usually in the hands of big businesses. or both. toll roads. but on the basis of who the borrower was. by setting up their own banks. Projects involving massive capital investments and long-term operating deals (in telecommunications. They ensure that commissioners represent their interests and maintain close relationships with the chairperson. There were cases where banks and borrowing companies were controlled by the same groups or families with strong political connections. and investing shares among nonfinancial companies within the group and in other groups’ companies. Family-controlled corporations were generally structured as a complicated web of affiliates and associated companies. In many cases. Corporations were certain that they could roll over short-term loans when these fell due. politicians. Families retain control by keeping the majority percentage of outstanding shares. They enhance their control over companies through cross-shareholdings. most often to people who were close to the ruling regime. In early 1998. The ultimate control of the corporate sector rests in the hands of a small number of families who own groups of companies.5 billion. II By mid-1997. and in the process maintain control of the company.38 Corporate Governance and Finance in East Asia. banks did not lend on the basis of the soundness of the project. contracts were granted to the private sector. This fact was usually not disclosed in financial statements. and power generation) require huge capital. Vol.5 billion was owed directly by corporations. This was often the case in the banking industry. . there was also almost universal confidence that the economic growth would continue indefinitely. High Ownership Concentration High concentration of corporate ownership (particularly by families) led to poor financing and investment practices. Collusion between big businesses and the political elite was widespread in Indonesia.
Chapter 1: Indonesia 39 1.0) 1999 2.18 shows that growth in most sectors significantly fell in 1997. Most sectors showed significant increases in leverage.8 7. Forestry.7 6. and building construction.7) 2.0 3. 1996-1999 (percent) Sector Agriculture.0 5.0) (15. Livestock. This continued in 1998. Sectors with lower ROE generally had higher DER.3 11.7 1998 (0.370 percent.1) 1.6) (3. The average DER was found to be 1. indicating a rapid rise in .5) (18. and 128 companies reported a total loss of Rp46.4 7. and Business Services Other Services GDP 1996 3.6 12.8 8. The JSX Monthly reported that total losses of 214 listed companies amounted to Rp39.6) (0.8) (11.7) (2.24 trillion for the first six months of 1998.4 5. BPS).8) (13.4 7. The construction sector was the worst hit.8 1997 1.1 5.18 GDP Growth by Sector.4) (0. Real Estate.6 8.3 Source: Central Bureau of Statistics (Biro Pusat Statistik. when all sectors.4) 2.2 (1. as shown in Table 1.1 (1. Table 1. Only 86 companies reported profits.6 13.6 4.0 2. except utilities.2 Impact of the Financial Crisis on the Corporate and Banking Sectors Impact on the Corporate Sector Table 1. The consumer goods industry reported the lowest ROE. followed by property. 53 companies reported negative equity of Rp6. and Restaurants Transport and Communications Financial. followed by the finance and trade sectors.9 3. and Fisheries Mining and Quarrying Manufacturing Electricity.7) (8. real estate. posted negative growth rates.8 0.5.2 8. Gas.58 trillion (meaning their losses were greater than the paid-up capital).1 6.6 (36. and Water Supply Construction Trade. Hotels. much higher than the 307 percent registered in December 1997.52 trillion.3 12. DER and ROE were calculated per sector.1) (26.19. Using the financial statements as of 30 June 1998 of 161 publicly listed companies.
2 13.0 105.625.0 307.9 12.0 158.0 229.1 (124.7) 6.21.4 5.0 631.1 (92.0 12.2) (264.0) (78. small foreign banks enjoyed the highest profits. and would have kept on increasing if interest rates had not declined.0 108.0 65.0 a ROE 1996 1997 1998a 14.2 23.2 (4. the NPL ratio rose to 25.4) 18.40 Corporate Governance and Finance in East Asia. several publications.0 219. The huge losses suffered by most companies were caused by three factors. from only 8.0 193. private banks posted negative ROEs in the same year.6) 15.3 7.0 191.097. Third.1) 7.1 (3.6) (115. II Table 1. First. losses in operation were due to declines in sales and increases in the cost of imported inputs.1) Note: DERs were calculated for only 161 companies (out of 214) that had positive equity.0 163.1 (5. interest expenses rose as credit rates increased from 20 percent in early 1998 to 40 percent in mid-1999.5 percent in April 1998. The table also reveals that although private national banks dominated the banking sector in terms of assets and credits.0 1997 234.7 1.370.8) 36.0 205. Vol. as shown in Table 1.0 2.0 92.0 635.1 1.6 (11. As the rupiah weakened and interest rates increased. but annualized to approximate full year values. This figure further increased to 47. the NPL ratio had reached more than 60 percent. Financial and banking analysts estimate that by September 1998.0 864. Second. Source: JSX Monthly. .0 1.20 reveals that the banking sector’s ROE decreased significantly in 1997.0 1.0 177.0 1998 186.271.0 111.8 17.395. 1996-1998 (percent) DER Sector Agriculture Mining Basic Industry Miscellaneous Industry Consumer Goods Industry Property Infrastructure Finance Trade/Services Average 1996 104. a Actual data for 1st semester only.0 177.4 (6.1 30.8 percent in 1996.0 72. Mostly suffering from a liquidity squeeze.8 (373.4) 8.7 percent in July 1998.5 8. Impact on the Banking Sector Table 1.19 DER and ROE of Publicly Listed Companies by Sector.0 2. foreign exchange losses came about with the use of unhedged foreign debt.0) 10. rupiah values of dollar-denominated debts due to the weakening of the local currency and the rapid decline in equity because of losses.0 697.0 108.0 97.0 1.
1992 7.69 14.2 — 19.9 297.2 48.24 (4.70 1995 7.1 274.0 129.20 ROE of the Banking Sector. Source: Infobank.5 128.4 7.73 30.09 (11.91 21.5 222.2 8. put pressure on the banking sector.8 11. coupled with negative spreads (deposit rate was higher than the credit rate).1 30.07 13. State-owned banks initially had the highest NPL ratio. . In July 1998.15 20. 1992-1997 (percent) Type of Bank State-Owned Banks Foreign Banks Joint Venture Banks Regional Development Banks Private National Banks Total — = not available.7 29.2 1.3 Private National Banks — 179.7 — = not available.9 — 11.50 9.8 187.28 5.0 622. however.5 34.45 — 1993 15.6 6.89 27.2 47.8 3.67 8. 230/1998.86 11.6 — 1.68 1996 1997 8.3 22.37 19.25 22.1 1.8 14.5 57.06 20.84 27.3 445.6 — 13.43 10.2 8.72 16.21 Nonperforming Loans by Type of Bank. 227/1998 and October No.1 198.9 percent.7 — 1.12 15.38) 11.30 5.2 10.47 20.6 — 4.81 13. The high and increasing NPLs.09 11.39 13. private national banks overtook State-owned banks when their NPL ratio jumped to 57.34 16. July No.7 106.9 Regional Foreign and Development Joint Venture Banks Banks — 9.3 361.1 47.0 — 32.0 — 4.5 31.Chapter 1: Indonesia 41 Table 1.8 8. Source: The National Banking Association.1 13.07 1994 14.45 21.5 2.7 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. 1996-1998 (Rp trillion) State-Owned Banks — 140.7 4.2 37.44 15.24 15.9 11.20) Table 1.2 — 8.
In June 1998. The scheme offered a hedging facility against rupiah devaluations for restructuring agreements. Total amortization payments due on foreign debt in 1998 were placed at $32 billion (before restructuring).5. companies were not servicing their debts. The scheme encourages negotiation between creditors and debtors. have been subject to restructuring deals under the initiative.4 trillion of domestic debt and $6. The committee was tasked to ascertain the level of private corporate sector debts and arrange negotiations between debtors and creditors. the Government and private sector formed a committee to help corporates deal with the crisis.6 billion) of Indonesia’s total external debt in March 1998.7 billion of foreign exchange debt.3 Responses to the Crisis Corporate Restructuring Measures At the end of 1997. few companies were in a position to resume interest payments. However. By end-November. Thus. Corporate debt accounted for 46. a number of prominent companies. the scheme failed. Since September 1998. Another option that companies could take under the Jakarta Initiative was debt restructuring via debt-to-equity swaps.7 percent ($64. by mid-September 1998. assembling the legal and policy framework to facilitate corporate restructuring. about 80 percent of which was private.000 eligible firms had signed up for the scheme. While the process of restructuring was in progress. II 1. 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. Unfortunately. only a . IBRA was formed to offer Mexican-style resolution for private sector foreign debt. In addition. Vol. Semen Cibinong (cement industry) became the first Indonesian company to resume paying part (25 percent) of the interest on its $1.42 Corporate Governance and Finance in East Asia. the Jakarta Initiative Task Force had conducted negotiations for 52 companies with Rp2. and Ciputra (property business). 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. particularly in terms of debt resolution. Astra International (automotive). a more comprehensive scheme to tackle domestic and foreign corporate debt.2 billion debt.000/$1) in debt from domestic commercial banks. none of the 2. the corporate sector had more than Rp600 trillion ($75 billion at Rp8. the committee launched the Jakarta Initiative. On 9 September 1998. Aside from being described as overly complicated. such as Garuda (a national flag carrier). In November.
Protection against insider and fraudulent transactions taken by a debtor prior to the adjudication of bankruptcy will be enhanced. with the requirement that adequate compensation and protection will be provided to such creditors during that period. Astra International. The Commercial Court can be asked to hold off creditors and impose strict guidelines on the negotiating process . especially in preventing unjustifiable delays in the adjudication of bankruptcy. mining. Bankruptcy Reform The Bankruptcy Law was passed in August 1998. Rabobank and Citibank. In the banking industry. 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. consolidate business units. A Commercial Court was set up to handle corporate restructuring and debt settlements. some companies attempted to restructure their businesses on their own. and sell noncore businesses or nonoperating assets. as well as general commercial disputes. Procedural rules are also being introduced to ensure certainty and transparency in the proceedings. i. Bank Bali agreed on a debt-to-equity swap with its creditor. focused on its core business of car and motorcycle manufacturing and sold off its subsidiaries in semiconductors. for equity infusion. a publicly listed company operating in the automotive industry. Astra International (automotive industry) and Bakrie Brothers (a holding company in several sectors) explored this option. lay off workers. 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. For instance. Moreover. under which the latter would become one of the bank’s shareholders. Bank Niaga also negotiated with some of its creditors. plantations. Some listed companies with relatively “rich” shareholders decided to replace their loans with additional equity through rights issues and privileged subscription (limited offering). forcing them to cut costs. Meanwhile.Chapter 1: Indonesia 43 few companies reached agreement with their creditors on this. the companies’ financial performance deteriorated. aiming to modernize the bankruptcy system and promote the fair and expeditious resolution of commercial disputes.e. Standard Chartered. When credit from the banking sector became unavailable and interest rates increased significantly. 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).. Debtors.
However.44 Corporate Governance and Finance in East Asia. The Government has also been concerned with the issue of capital controls. Realizing that they undermine investors’ confidence. in consultation with IMF and the World Bank. companies were allowed to sell shares only by issuing stock rights. Vol. Banking Sector Reforms The Government’s banking sector reform strategy is focused on (i) government-assisted recapitalization programs for potentially viable private banks. The bias in favor of debtors has retarded the pace of corporate restructuring. legislation against corruption. with only 17 cases filed as of November 1998. collusion. and nepotism (anti-KNN) was signed in 1999. . There will be changes in the implementation of the bankruptcy law. II to achieve liquidation of the company. since the market reflects the condition of the economy. 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. To push bankruptcy reforms. The Court has also declared only two companies bankrupt. The Government. it is envisaged that the Commercial Court will play a central role in modernizing the commercial legal system. Capital Market Reform In the capital market. the Capital Market Supervisory Agency allows companies to offer additional shares directly to the public. reform. The Agency also allowed companies to buy back up to 10 percent of outstanding shares to improve the condition of the stock market. the Court’s early record has been a disappointment. and recapitalization of state banks. Rather. Previously. (iii) the merger. However. In the longer term. the Government did not impose restrictions nor did it attempt to regulate capital flows. and (v) a strengthened banking supervision system. 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. (ii) the resolution of nonviable private banks. Some companies simply decided not to pay their loans knowing that it would be difficult for creditors to take the case to court. including procedures for handling operational issues and processing bankruptcy cases. (iv) measures to recover liquidity support previously extended to troubled banks by Bank Indonesia. the measure had only a minimal impact. is also reviewing the Bankruptcy Law.
Chapter 1: Indonesia 45 In 1997. To obtain a clearer picture of the banking sector. The merger process will be finished within two years. A new central banking law. depositors will be fully protected by the Government. regulations will need to be issued to permit debt-toequity swaps in the context of corporate restructuring plans. 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 . and Recommendations Summary and Conclusions Corporate Ownership and Structure Most of Indonesia’s top conglomerates were established as family businesses. the Government has drafted a regulation providing tax neutrality for mergers and removing other tax disincentives for restructuring. To overcome these problems. Banks deemed ineligible for recapitalization will be closed. In particular. However. providing Bank Indonesia with substantially enhanced autonomy. The Company Law at present can be interpreted as severely limiting the scope for debt-equity swaps. or sold (after transferring NPLs to the AMU). The importance of this legislation may need to be emphasized. and Bapindo) will be merged into one bank named Bank Mandiri. It has also drafted regulations to remove obstacles for converting debt to equity. 1. BBD.6 1. the Government required banks to be audited by international external auditors. Other Regulatory Reforms To push corporate restructuring further. the Government established IBRA to supervise problem banks. improvement of rules and prudential regulations. Liquidity support given to troubled banks should be repaid in four years. The four state banks (BDN. BEII.1 Summary.6. was enacted in 1999. it is doubtful whether pure holding companies are able to enter into swaps. and follow-up action on bank restructuring. Conclusions. In October 1998. Bank Indonesia has announced a recapitalization program for potentially viable private banks. The Bank Indonesia 21st package includes recapitalization. The agency set up an Asset Management Unit (AMU) to directly manage problem loans of banks under its supervision. merged.
conglomerates set up finance companies to bring in cheap foreign loans as these companies were not adequately regulated. As a result. retain ownership control of companies. The restructuring and resolution of financial distress may. allowing them to maintain their equity shares and. II 53 percent of total assets of the top 300 Indonesian conglomerates.6 percent of the total stock market capitalization in 1996 and the top 15 families controlled 61. But because foreign creditors were reluctant to lend long term. However. 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. Indonesian companies borrowed short term. Foreign creditors. On average. conglomerates set up their own banks to serve as “cashiers” providing credit to companies within groups. not all of the conglomerate-affiliated companies are publicly listed. thus. Among those listed in the Jakarta Stock Exchange. the majority remains family-controlled. These figures show the extent of power wielded over the corporate sector by a small number of families. families control 67. this financing pattern supports the claim that family-based controlling shareholders relied on excessive borrowing to finance corporate expansion . corporate debts grew over time. lacked the information necessary to allow them to assess projects’ risks and chances for success.1 percent of publicly listed companies in Indonesia. The free capital flow system permitted the inflow of foreign capital to fuel the credit boom in the economy. Financing Patterns Controlling shareholders opted to use debts to finance expansion. Companies relied heavily on bank credit. When the Government regulated the legal lending limit and the net open position of banks. The financial crisis created opportunities for addressing the inefficiencies in the legal and judicial system that supported corruption. Rapid growth in investments masked the corporate sector’s increasing leverage. when barriers to entry in the banking sector were lifted.46 Corporate Governance and Finance in East Asia. while a single family controlled 16. banks were unwilling to provide credit to highly leveraged companies. On the one hand. Therefore. These banks also obtained cheap offshore funds. Vol. put a significant amount of corporate assets of conglomerates in the hands of creditors or the Government. meanwhile. however.7 percent. This study reveals that Indonesian listed companies with higher ownership concentration had higher levels of leverage. However.
To restructure the corporate sector. The Government and the private sector responded with measures to mitigate the negative effects. NPLs rose and capital adequacy ratios fell. financed by issuing nearly $80 billion worth of bank restructuring bonds. Meanwhile. although at a declining rate. corporate-initiated debt restructuring . When the crisis hit Indonesia. the high domestic interest rates that prevailed from 1998. As the rupiah weakened and interest rates increased.370 percent in 1998. and registered a net loss of Rp39. the corporate sector was in quite good shape in terms of growth and profitability. the Government initiated corporate debt restructuring measures (Mexican-style foreign debt resolution and the Jakarta Initiative). At the height of the crisis. Total profits of publicly listed companies dropped to Rp3. it also reflects the failure of the financial sector to channel funds to the corporate sector efficiently due to weak prudential regulation and supervision. followed by the property sector. The problem was in the maturity structure of its dollar-denominated debt and high debt-to-equity ratios in some sectors.24 trillion in the first half of 1998. the consumer goods industry was the worst hit. Net profits of publicly listed companies had consistently been growing at an average rate of 20 percent each year. Sales of conglomerates as well as those of publicly listed companies were increasing. and strengthen prudential regulations and supervision of the financial sector.21 trillion in 1996.Chapter 1: Indonesia 47 without diluting their control. On the other hand. Impact of the Financial Crisis Prior to the crisis. the highly leveraged companies. ROE dropped from 1.1 trillion in 1997 from Rp13. The financial crisis led to the closure of several dozen banks. The significant increases in leverage indicate a rapid rise in the rupiah value of debts due to the revaluation of dollar-denominated debts. facilitate debt restructuring. The Government introduced reforms to improve bankruptcy procedures. were the most adversely affected.1 percent in 1998. and the rapid decline in equity due to losses. Responses to the Crisis The impact of the financial crisis on the corporate sector was serious. particularly those with large short-term foreign loans.1 percent in 1997 to -124. DER increased to 307 percent in 1997 and further surged to 1. Bank Indonesia extended emergency loans to many banks.
Protecting Minority Shareholders’ Rights The Corporate Law provides sufficient rights and protection for all shareholders.. the regulatory environment was not prepared to supervise the increasing number of banks and nonbank . (ii) delineating the functions of the board of directors and commissioners. and (iii) strengthening transparency and disclosure requirements. 1. but it is not clear whether in practice these standards are in place. 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. In particular. The Corporate Law should be reviewed and amended in the context of pervasive control by large shareholders. but inadequate protection to minority shareholders from the dominance of large shareholders. Most companies claim to have adopted international standards of accounting and auditing procedures. Vol. the legal system is less likely to evolve in a manner that will allow it to protect minority shareholders. improving the legal and regulatory framework for bank supervision.g. and protecting creditors’ rights.6. 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. minority shareholders have not been able to oppose controlling shareholders’ decisions to invest in unprofitable projects financed by unhedged foreign currency debts. Improving the Legal and Regulatory Framework for Bank Supervision After the liberalization of the financial sector. II measures included internal business restructuring (e.2 Policy Recommendations The Government should introduce measures to address the weaknesses in corporate governance identified in this study. The Government should ensure that all laws and regulations are effectively enforced. cost cutting and business consolidation) and acquisitions by creditors or foreign investors through debt-to-equity swaps and equity infusions. Specific recommendations include protecting the rights of minority shareholders.48 Corporate Governance and Finance in East Asia.
recapitalization. The Central Bank needs to monitor and control dealings by banks within business groups and improve enforcement methods to prevent circumvention of prudential regulations. orderly restructuring. However. The ownership of banks (including finance companies) by shareholders of nonfinancial companies undermined the capability of these banks to conduct prudential credit management. the Republic of Korea and Thailand were more successful in getting foreign creditors to collectively solve their problems during the crisis. 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 Government lost monitoring and control powers over foreign fund flows. The regulatory framework was also weak in supervising and monitoring foreign transactions. it has been difficult to implement standstills. and liquidation of corporate assets. the Court has been slow and ineffective in processing bankruptcy suits. Consequently. with necessary legal sanctions for violations.Chapter 1: Indonesia 49 financial institutions. With credit being coursed through the domestic banking system rather than directly to numerous local corporations. Protecting Creditors’ Rights To protect creditors’ rights. Because foreign creditors are faced with more information asymmetries than domestic creditors. One way is to set limits on lending activities by banks to affiliated nonfinancial companies. most of banks’ NPLs resulted from credit to companies within the same group. the banking regulatory framework was inadequate in regulating banks’ dealings with affiliated nonfinancial companies. it is likely that future private financial flows for the corporate sector will continue to conform to a short-term structure. Further. in contrast to the Republic of Korea and Thailand. When finance companies were used to channel offshore loans in lieu of commercial banks. Because these banks are neither easily convinced nor compelled to submit their claims to the jurisdiction of Indonesian commercial and bankruptcy courts. the Indonesian corporate sector directly owes an inordinate amount and a greater portion of its loans to foreign banks. This is a significant factor in . The Government should also continue strengthening the monitoring system for foreign exchange transactions. a new bankruptcy law was passed in the aftermath of the crisis and a Commercial Court was set up to deal with bankruptcy cases. Banks should be required to provide data on such transactions and charged penalties for noncompliance.
. 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. despite the smaller level of capital inflows (as a percentage of GDP). II explaining the greater depth of the crisis in Indonesia.50 Corporate Governance and Finance in East Asia. Only when creditors have the confidence that their rights are protected will they resume financing companies. Vol.
and Remuneration. 1999. 1998.. Indonesian Business Data Centre. Financial Sector Practice Department. various publications. Working Paper #58. 14 May 1999. Embassy of Indonesia Homepage. Jonathan. 1997. 1995. F. Lang. 1997. Letter of Intent of the Government of Indonesia to the IMF. Center for International Business Education and Research. Large and Medium Manufacturing Statistics. Conglomeration Indonesia: Regeneration and Transformation into World Class Corporate Entities. World Bank. Indonesia Country Profile. Indonesia: An Emerging Market. Asia in Crisis: The Implosion of the Banking and Finance System. Simeon Djankov. Indonesian Business Data Centre. Conny Tjandra Rahardja. Indonesia: Sustaining Manufactured Export Growth. Corporate Governance: Responsibilities. University of Maryland. various publications. Jakarta Stock Exchange. Maryland. JSX Monthly Statistics. Michael Krill. 1999.Chapter 1: Indonesia 51 References ADB Programs Department (East). Wright. 1996. Embassy of Indonesia. Economic and Financial Statistics. The Private Debt Anatomy. Keasey. The Economist Intelligence Unit. K. Claessens. Indonesian Central Bureau of Statistics. Economy of Indonesia. 1998. 1996. The Impact of Acquisition to Shareholders Wealth: Comparison Between Internal and External Acquisition. John Wiley and Sons. Indonesia Country Report. Manuscript. and Larry H. Stijn. Bank Indonesia. Risks. and Richard Turtil. . Unpublished thesis MMUGM. Institute for Economic and Financial Research. Delhaise. Forest. Yogyakarta. P. 1995. various publications. The Economist Intelligence Unit. various publications. Who Controls East Asian Corporations? Financial Economics Unit. P. and M. John Wiley and Sons. Indonesian Capital Market Directory 1992-1998.
and curtailing of morally hazardous behavior that has been prevalent among economic decision makers. David Edwards. This has been the crux of the corporate governance problem in Korea. Further. the Korea Stock Exchange for its help and support in conducting company surveys. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. Department of Economics. a practice that was not checked by creditors. timely exit of poor performers from the market. 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. It had been the norm in Korea to conduct business based on political and administrative favoritism rather than on competitive merits. 1 Professors. and corporates were sent reeling. internal control mechanisms. markets. the Government and business sector had good reason to reflect on the causes of the crisis. Business managers and controlling shareholders were maximizing firm size at the expense of profits. the Republic of Korea.1 Introduction The economic crisis that began in Thailand and swept through Asia starting in the summer of 1997 hit the Republic of Korea (henceforth. As the Korean currency.2 Republic of Korea Kwang S. both of ADB. or capital market discipline. Inefficient investment coupled with excessive financial leverage was found to be at the root of the economic crisis at the corporate level. The authors wish to thank Juzhong Zhuang. . The extent of inefficient investment can be seen from the fact that more than 70 percent of listed firms had negative economic value added (EVA) before the crisis while those with positive EVA declined (Table 2. The country’s winners would then emerge based only on economic efficiency. Chung and Yen Kyun Wang1 2.1). and Graham Dwyer for his editorial assistance. Poor corporate governance and political and government intervention in the business and financial sectors are widely viewed as contributory factors. Chung-Ang University. 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. Seoul.
1 1996 561 163 29.1 Listed Firms with Positive Economic Value Added. Source: Korea Stock Exchange. accountability of controlling shareholders and boards of directors. especially chaebols. and individual companies. 1992-1998 Item Total Number of Firms Firms with Positive EVA Percentage of Firms with Positive EVA 1992 508 180 35. II Table 2. 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. Government reform goals for the corporate sector include enhancement of corporate transparency. A survey was conducted for the nonfinancial listed companies using a questionnaire developed by the Asian Development Bank (ADB)2 to supplement official data. Restructuring efforts have focused on reduction in the degree of business diversification and in the financial leverage of large-sized firms. the corporate sector. This study collects and analyzes data on the Korean economy. and J Murrin (1995).1 1997 518 104 20. capital market discipline. where NOPAT is the net operating profit after taxes and WACC is the weighted average cost of capital multiplied by invested capital. This study also reviews the legal and 2 The survey was conducted mainly through the Korea Stock Exchange.4 1993 513 174 33. and improvement of bankruptcy procedures.54 Corporate Governance and Finance in East Asia. which distributed and collected the questionnaire. T.5 Note: The EVAs are calculated as: EVA = NOPAT – WACC. aiming to identify the areas in need of further reform and to provide policy recommendations for improved corporate governance.1 1995 560 163 29.1 1998 490 164 33. Koller. This broad perspective can help clarify the ongoing reform efforts of businesses and the Government. . Dividend payments were at less than 2 percent annually as opposed to the double-digit interest rates in the past decades.9 1994 531 165 31. The EVAs are the same as the economic profit as explained in T. Copeland. Weaknesses in the overall corporate governance system in Korea had many ramifications. Inefficient investment undermined the competitiveness of Korean firms in the global marketplace. Vol. June 1999. Many firms left some questions unanswered. The total number of respondents was 81 out of about 550 nonfinancial firms listed on the Exchange.
Section 2. 2.2 presents an overview of the corporate sector. In the period 19481961.1 Overview of the Corporate Sector Historical Development3 The development of the Korean corporate sector is closely related to the progress of the economy. Major economic indicators for some of these periods are shown in Table 2. and employees and their role in shaping corporate governance practices. Section 2. It traces the country’s economic development. the Government relied heavily on aid from the United States (US) and United Nations to alleviate poverty and high inflation. Import Substitution: 1948-1961 The Korean War (1950-1953) devastated Korea’s industrial capacity. the board of directors system. and Yim (1998). This chapter is composed of six sections. 3 The review of historical development of the Korean economy draws substantially from the book by Sohn. corporate control by the Government.2 2.2.5 describes the state of the corporate sector in the financial crisis and draws on the results of the foregoing sections to outline the causes of the crisis. reviewing government policies responsible for the development of the modern corporate sector. . which account for a substantial portion of the Korean economy. Yang. Section 2. The Government tried to produce food.2. and naturally adopted an import substitution policy. clothing. the import liberalization rate was below 7 percent and the average tariff rate was in the range of 25 to 30 percent. Section 2. The evolution of the modern Korean economy can be divided into four periods. Section 2.4 contains analyses of corporate financing and its relationship to performance.3 identifies characteristics of corporate governance by analyzing the ownership structures and control patterns of listed companies and the largest chaebols. From 1948 to 1961.Chapter 2: Korea 55 regulatory framework for the corporate sector and reform measures taken after the crisis. It then presents recommendations for further reform in corporate governance and financing. and other necessities domestically.6 discusses responses of the Government and the business sector and explains in detail their reform and restructuring efforts. creditors. It reviews such elements as shareholders’ rights.
and inconsistent economic policies.9 — — 21.5) (1.9) 1.8 (8.265.4 (1.2 757.753. and implementing new budget and tax measures.2 31. the Government redirected the policy focus away from import substitution to an export-led manufacturing-based economy.2 452.5 250. Export Drive: 1962-1971 Between 1962 and 1971.5) 8. 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. Vol. high unemployment and inflation. II Table 2.0) (297.1a 21. b Refers to 1979. d Refers to 1997.5 38.4 24.2 1. e For maturities of one year or more.1 15.8 15.0 27.7 14.2 32.9) (7.0 41. However.2 314.2 1980-1989 8. In the Plan. Economic Statistics Yearbook.102.4 29. The Government tried .1 9. the Government called for an unprecedented average annual economic growth rate of 7.9b 15.8 (724.7c 11. and large current account deficits.9 794.7 37. largely because of political instability.1 29. Source: Bank of Korea.56 Corporate Governance and Finance in East Asia.447.2 Key Macroeconomic Indicators Annual Average (percent.4 1990-1997 7.949. a Refers to 1971. In 1961 it devalued the won from W65 to W130/dollar and announced its first Five-Year Economic Development Plan (1962-1966). 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 8.2 30.1d 9. This goal required very high savings and investment rates.1 percent with moderate rates of inflation and introduced a series of reform packages aimed at developing key industries.855. c Refers to 1989. IMF. International Financial Statistics.8 12.1 35.6 11.8 24.4 10.2 6. modernizing the industrial structure.7 30. lack of strong drive.1 — = not available.0) 492.332.3 8.4 29. the Government was not successful in solving the problems of slow growth.
and maximizing mobilization of domestic savings on the other.3 percent average between 1954 and 1959.2 billion in 1972. but the average growth rate for 1965-1969 shot up to 10 percent. However. a modest improvement over the 4. but tariff rates were raised to 40 percent in the 1960s.4 percent.3 percent to 60. abundant. 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. The exchange rate system was a kind of crawling peg until 1974. Also. the Government changed the multiple and fixed exchange rate system to a unitary floating exchange rate system. Korea normalized political and economic relations with Japan to encourage inflows of Japanese capital that could finance big development projects. 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. The Government abolished temporary direct subsidy measures and introduced a new comprehensive export promotion system. . channeling funds from curb markets into the banking sector. the Government undertook important economic reforms in two areas: the foreign exchange rate and the interest rate. These were considerably liberalized in 1967 when Korea joined the General Agreement on Tariffs and Trade (GATT). The well-educated. The average growth rate of the economy from 1960 to 1964 was 5. In 1971. But the liberalization trend turned out to be short lived as current account deficits continued. up from 30 percent in the late 1950s.5 percent. In 1964. imports of consumer goods and luxury items were highly restricted. During the first five-year plan period. the Government tried to provide exporting firms with a free trade environment.Chapter 2: Korea 57 to meet its targets by borrowing large amounts of foreign capital on the one hand. and almost doubled the foreign exchange rate from W130/dollar to W256/dollar to enhance the international competitiveness of exports. The positive list system for imports was replaced with a negative list that indicated only those items that could not be imported. resulting in high real interest rates. the import liberalization rate was 55 percent. while the average tariff rate was 39 percent. boosting internal investment resources. This change raised the import liberalization rate from 9. Exports increased sharply from $41 million in 1961 to $2. due to continuous current account deficits. In 1963-1964. and cheap labor force was well utilized by the export-led growth strategy. which laid a solid foundation for a steady growth path. Bank deposits increased rapidly. During this period.
One industrial policy adopted during the heavy and chemical industrialization drive was administered credit rationing. shipbuilding.6 billion between 1973 and 1981 into these sectors. the Government felt the need to strengthen the defense industry. and allocating virtually unlimited amounts of credit at below-market rates while controlling the financial system. Unlike the previous system. where preferential export credit was given to almost every exporter. The Government took emergency measures. and chemicals—as future core industries. It included a detailed construction and investment schedule over a 10-year time frame and mandated coercive implementation. announcing rescue packages for businesses and banks. and assigned them to specific chaebols. faced the danger of bankruptcy. The Government encouraged a variety of business projects. By promoting HCIs. in the face of a world economic slump. Second. It promoted HCIs by supplying massive capital for construction and development. machinery (including automobiles). and giving low interest rate loans to banks from the central bank. In 1972. This strategy formally took off with the announcement of the HCI Promotion Plan in June 1973. The Government targeted six industries—steel. These practices contained an implicit government guarantee that large businesses and banks could never fail.58 Corporate Governance and Finance in East Asia. There were three reasons for the switch: first. it tried to substitute imports and export high value-added HCI products. reducing or exempting debts of farmers and fishermen. Vol. the Government changed its industrial policy emphasis from light industries to heavy and chemical industries (HCIs). The Government has since used similar emergency rescue measures for large businesses and banks almost once every 10 years. overburdened with debts and high interest rates. electronics. II Heavy and Chemical Industry Promotion: 1972-1979 In the Third Five-Year Economic Development Plan (1972-1976). less developed countries forced Korea to adjust its industrial structure. nonferrous metal. the emergence of competition of other low-wage. 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 . the Government felt that continuous trade deficits arising from increasing intermediate and capital goods imports could be prevented by developing import substitution industries. These included rescheduling business debts. the domestic economy was stagnant and many businesses. The HCI promotion policy was much more comprehensive than past economic development plans. investing a total of $9. becoming a seed of the economic crisis in 1997. Third.
low .Chapter 2: Korea 59 through state-controlled banks. especially between 1979 and 1985. including denationalization of banks. Korea recorded current account surpluses and rapid economic growth due to the “three lows”: low value of the US dollar.2). exacerbated the overcapacity problem. The growth rate of the money supply was reduced drastically. Meanwhile. faced with high inflation. The two important ones were import liberalization and deregulation of the financial sector. met increased difficulty. and the won depreciated by 20 percent with the adoption of a Basket-Currency Gliding System in 1980. The industrial and trade policy resulted in high inflation in the 1970s and serious excess capacity problems by 1979. and the large excess capacity of HCIs. Meanwhile. various measures to increase competition were taken. Such an approach gave the Government increased control over the economy. coupled with political uncertainty due to the assassination of President Park in 1979. with many turning into the now well-known chaebols. Cheap credit and distorted prices resulted in overexpansion in the HCIs. However. Evaluations of HCI promotion policies are mixed. imports were further liberalized while tariff rates were lowered. the policy wasted substantial amounts of resources in the short and medium terms. and their utilization ratios were very high. Gross national product (GNP) growth rates on average were higher in the 1972-1979 compared to 1962-1971 (Table 2. This required industrial restructuring by the Government. however. including forced liquidations and mergers and acquisitions (M&As). The severe world recession caused by the second oil shock. Macroeconomic policies became hostages of the industrial strategy. a heavy foreign debt burden. the Government restructured some large businesses through forced liquidation and M&As. such as widespread underutilization of capacities of HCIs and related plants. fiscal expenditure maintained zero growth. as it had to control only a few large chaebols. the Government adopted comprehensive measures to promote economic stabilization. New start-up firms. light manufacturing and service industries were weakened by disadvantages such as a lack of credit. In 1986-1989. In order to improve economic efficiency. Economic Liberalization and Globalization: 1980-1997 In 1979. since during the second half of the1980s many of the promoted firms became world-class competitors and exporters. Firms that followed the Government expanded greatly. The incentives available became more market-based. price controls were abolished. The plan of the 1970s was thought to be successful in the long run.
and acceded to the World Trade Organization (WTO) in 1994.9 percent. In 1993.9 percent. which gradually widened. . with the 30 largest in the total economy in 1997 standing as follows: value-added. Industrial and trade policies were modified to be consistent with WTO. 45. 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.1 percent and average tariff rates 8. 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).9 percent. By joining the Organisation for Economic Co-operation and Development (OECD) in December 1996.60 Corporate Governance and Finance in East Asia. total assets. total debts. where particular individuals and their family have de facto control of the management of all subsidiary companies of groups. Korea adopted a market average exchange rate system. 2.3 percent. total sales. Meanwhile. giving up its foreign exchange controls related to the current account. Vol. 46. II world interest rates. and total workforce.1 percent. whose business activities are controlled by an identical person. The most important element characterizing chaebols is the concentration of ownership. 47. Korea abolished remaining direct subsidy systems for export activities as well as some traditionally managed trade systems. the import liberalization ratio reached 98.” A large-scale business group is called a chaebol. but it chose to liberalize gradually. the Government committed itself to further liberalization of the goods and capital markets. while continuous and large current account surpluses saved Korea from the foreign debt problem. Korea became a signatory country to the International Monetary Fund (IMF) Article VIII. further increasing its pace of import liberalization. The Government tried to adjust economic policies and regulations to meet global standards. and declaring that it would follow Article XI of GATT. joined the Asia Pacific Economic Cooperation (APEC) Group in 1993. In 1990.2 percent. the importance of chaebols was increasing. and low oil prices. 4. The low value of the dollar led to a low won and high yen.2 Rise of the Large Business Groups (Chaebols)4 The Korean Fair Trade Act defines a business group as “a group of companies. Korea began participating in many multilateral trade negotiations during the Uruguay Round. The official rate fluctuated within a band. In 1988. 13.2.
This policy contributed greatly to the expansion of chaebols. reaching 669 in 1996. after the financial crisis. financial assistance. the Korean Government has set the national goals of economic development and offered all kinds of support and incentives to achieve them.5 20. The Government provided financial and fiscal incentives to chaebols and trading companies with relatively abundant financial resources. Table 2. the number of subsidiaries declined drastically due to corporate restructuring.when the Government put a great deal of emphasis on development of the HCIs.1 20. One reason for this controlling power is inter-company shareholding among subsidiaries. However. . of Subsidiaries 604 616 623 669 Average No. The Government provided subsidies.3 shows that the number of subsidiaries of the 30 largest chaebols increased considerably since 1993. Table 2. the ownership and management of a chaebol’s subsidiaries are not separate. it was more effective to deal with a small number of companies to secure tangible outcomes. Since the 1960s. Since the Government controlled most business activities. In this sense.Chapter 2: Korea 61 War II. In the mid-1970s. Important managerial decisions are made primarily by owners. Chaebols have a history of substantial concentration of ownership. From the standpoint of the Government. This galvanized the fast growth of chaebols. and tax breaks to key industries to promote exports and industrial upgrading. 1993-1996 Year 1993 1994 1995 1996 No. Subsidiary companies of chaebols are subject to “fleet-type management” in that they are controlled by the overall managerial system of chaebols. and they are aided and supported by one another. large-scale businesses and chaebols were thought to be appropriate actors because they could meet the huge investment requirements of these industries. 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 Subsidiaries of the 30 Largest Chaebols. Chaebols are also excessively diversified.8 22. of Subsidiaries per Chaebol 20.3 Source: The Fair Trade Commission. chaebols that maintained a close relationship with the political authorities were able to grow fast.
chaebols can benefit from synergies. Under this law. II Theoretically. This could ensure their stable growth and enhance their investment abilities.62 Corporate Governance and Finance in East Asia. including the “economies of organizational size” inherent in multi-product and multiplant firms. Another law that contributed to the development of the stock market was the Act to Expedite the Going Public of Corporations of 1972. This law was in effect until 1987 when it was partly absorbed into the Capital Market Development Act. listed companies enjoyed corporate tax rates that were 10 to 20 percentage points lower than those imposed on privately held firms. they can reduce uncertainties and dilute risks through sharing of information and diversification.2.3 Role of the Capital Market and Foreign Capital In the 1960s. The law also allowed employees of listed firms to get 20 percent of the subscription rights in offerings of new shares. On the other hand. etc. . Since chaebols are engaged in many different businesses. However. Related to this is the tendency of chaebols to assist unprofitable firms at the expense of profitable ones. if a chaebol has an unsound financial structure but strong financial links through mutual payment guarantees among their subsidiaries. the Government reviewed the financial performance of companies and recommended (or ordered) selected ones to go public. which may ultimately lead to the decline of social efficiency. 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. Vol. the Government’s efforts to develop the stock market culminated in the Capital Market Development Act of 1968. and were allowed extra depreciation charges for tax purposes. the bankruptcy of one or a few marginal subsidiaries could lead to a chain of bankruptcies for the entire chaebol. in addition to the usual economies of scale. there are many negative assessments of organizational structures and practices of chaebols. diversification can make chaebols stable through the portfolio effect. internalization of the market that could enhance the internal efficiency of a chaebol may close the market to other firms. They had to meet certain requirements in terms of firm size. 2. years since establishment. For example. profitability. 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. In the early years after the enactment of the law. Meanwhile.
370 70.0 79. The Korea Fund.5 406.9 918.2 44.217 141. 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). a country fund. . the stock market grew rapidly during the 1980s. First.151 117. The aggregate Table 2. the Government attempted to stabilize the stock market by limiting IPOs and share issues by listed companies. Because of government policies and the booming economy.1 30.9 833. Third. This reversal in policy reflected declining stock prices and was generally maintained until the outbreak of the economic crisis in 1997. Second. In this regard.Chapter 2: Korea 63 During the 1980s and 1990s. The policy to expand the size of the stock market.0 49.6 Year 1985 1989 1990 1994 1995 1996 1997 1998 Source: Monthly Review (Securities Supervisory Board) and the Financial Supervisory Service. several important policy measures were implemented to promote the development of the stock market. As shown in Table 2.1 16.4 40. Also that year.570 95. the Government announced measures to increase the demand for shares by providing tax and financial incentives to individual investors.7 934. continued until 1989.020 151..4 Development of the Stock Market.4 654.6 747.1 Market Capitalization (W billion) 6. 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. especially those paying small or no dividends. the Government announced the gradual opening of the capital market to foreign investors in January 1981.9 34. mainly by increasing the supply of shares by initial public offerings (IPOs) and seasoned issues.989 137.798 Market Capitalization as a Ratio to GDP (%) 8.476 79.0 965.4. Inc. Beginning 1990. 1985-1998 No. of Listed Firms 342 626 669 699 721 760 776 748 Stock Price Index 138. in 1986 the Government imposed limits to bond issues on firms that were recommended to go public but refused. however. was established to invest in domestic shares beginning in September 1985.
Table 2.924 (1. Source: Balance of Payments. currency and deposits.542) (1.658) (3.455) 13.382 Permit basis.414) 5.742 (3.953 10.553 8.5 shows net FDI—inward investments by foreigners less outward investments by Koreans—in the period 1985-1998. foreign direct investment (FDI) has been very small relative to GDP and compared to other East Asian countries.694) 2. The relative size of the stock market diminished to 44 percent in 1990. and stayed at the 30-40 percent level up to 1996. The growth in the number of listed firms also slowed in the 1990s.944) 8. Vol.785 (1. Table 2.870) (1.546 (2. but increased sharply to 79.800 (7.450 24.737 (333) (297) (607) (2) 218 2. II market value of all listed firms represented only 8 percent of GDP in 1985.5 Private Capital Flows to Korea.453 (2.123 3. but rose again to 34.183 12.817 16. Bank of Korea.001 4.910) 2.500 7.149 13.642 21.868 (518) (418) 63 1. .352 471 3. The number shrank for the first time in 1998 to 748 firms from 776 the previous year. Other investments include loans.255 2.714 1.2 percent by 1989.296) (6. due to declining stock prices.852) (2. 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) (2.64 Corporate Governance and Finance in East Asia. and 1993.150 5.433) (9.858 4.141 4.59 percent in 1998 and to more than 50 percent in the early months of 1999.534) 1.085 2.264) (3. However.347 3.017) 1.338 4.650 (1.008) (3.239 19.413) 56.86 percent of GDP in 1997. and other liabilities.942) 42.339) (9.571 2.126 (1.583 25 10. trade credits. Korean companies borrowed substantial amounts of foreign capital due to the excess of investments over savings and chronic current account deficits—except in the period 1986-1989. The aggregate market value of listed shares bottomed at 16.440 1. The reasons for the decline include increases in bankruptcies and mergers involving listed companies since the outbreak of the economic crisis.875 21.326 1.287 (340) 73.
Between 1986 and 1989. weak incentives for attracting FDI. Table 2.2 percent in 1987.4 Growth and Financial Performance This section looks at the performance of (i) the aggregate corporate sector.Chapter 2: Korea 65 Complicated government regulations.6). The contribution of the corporate sector to GDP was 73. Japan’s was consistently higher. 2. The same categories will be analyzed in later sections. Return on equity (ROE) and return on assets (ROA) showed similar patterns. Corporate sector net proft margins increased from 1993 to 1995. Net private capital inflow. The growth rates of total assets.7 billion and loans $42. portfolio investments amounted to $73.7 compares the ratio of ordinary income to sales of Korea’s manufacturing sector with those of Japan. increased substantially in 1994-1996 due to accelerated liberalization of capital movements (Table 2.5). other net private capital inflows amounted to $130 billion during 1985-1998. equity. (ii) listed firms. but dropped in 1996 and were negative by 1997. The dismal performance of the Korean corporate sector compared to the . but between 1988 and 1993. The debt-to-equity ratio (DER) averaged 311 percent for the period 1990-1996 and peaked at 424. This would lay the foundation for evaluating the effect of corporate governance on performance. Korea had substantial current account surpluses and experienced net private capital outflow.China. and sales of the aggregate sector during this period were very high (Table 2.9 billion. The ratio is generally in the same range for Japan and Korea. Profit rates of Korean firms were relatively low compared to those of Taipei. and US. In addition to FDI. This indicates that a substantial proportion of debt was denominated in dollars.2. However. The Aggregate Corporate Sector The aggregate corporate sector in this study excludes the financial sector. and (iii) chaebols.China and the US. Taipei. Of this. excluding FDI.6 percent in 1997. the growth rates of equity and sales dropped sharply in 1996 and 1997. following the sharp depreciation of the won. increasing to 76 percent in 1997. and high production costs were the main reasons for low FDI in Korea. Large amounts of outward investment by Koreans in the mid-1990s arose out of increased liberalization of foreign exchange regulations.
6 Growth and Financial Performance of the Nonfinancial Corporate Sector.9 5.5 7.2 1.0 0.4 2.8 22.9 13.1 2.7 4.3 21.9 3.6 3.2 13.8 1.3 14.7 International Comparison of Ratios of Ordinary Income to Sales in Manufacturing (percent) Year Korea US Japan Taipei.Table 2.1 5.5 1. ROE = return on equity (ratio of net income to stockholders’ equity).0 8.9 4.0 4.6 318.7 15.0 13.3 308.7 3.9 18.7 3.2 19.4 19. ROA = return on assets (ratio of net income to total assets).7 4.3 17.8) 297.8 3.4 1.4 2. Source: Bank of Korea. .3 11.2 1.3) 5.7 4. Ordinary income = operating income + nonoperating income (from financial activities) – nonoperating expenses (from financial activities).9 3. Financial Statement Analysis Yearbook.8 2.4 1.4 — 6.6 13.6 (4.2 18.3 1.5 1.7 15.0 7.0 6. Note: Ratio of ordinary income to sales = (ordinary income/sales).9 2.9) DER = debt-to-equity ratio.0 (0.0 13.6 9.3 6.1 2.2 13.3 3. Source: Bank of Korea.9 8.5 2.5 1.9 16.9 5.3 — 3.6 1.4 2.1 6.9 2.4 10.5 0.6 1.0 3.3 335.6 2.5 4.2) (0.9 18. Financial Statement Analysis Yearbook.9 5.China 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 2.8 1.6 424.1 2.8 21.5 (0.7 325.1 — — — = not available.3 312.9 2.0 10.7 2.1 8.0 305.3 21.8 8.2 1. Table 2.4 4.9 16.7 1. 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 9.5 4.5 3. Net profit margin = ratio of net income to sales.6 4.4 1.
. Profit rates of different industries also mirrored the downward trend of the aggregate corporate sector prior to the crisis. Growth rates of total assets are generally high. The manufacturing. ROEs. gas. followed by mediumsized firms and large ones. trade. Profit rates of most industries are also quite low. 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. with the wholesale and retail trade sector and the construction sector having the highest figures.and small-scale firms (Table 2. and transport sectors recorded negative profit rates in 1997. In 1997. the exception being the electricity. This preference of Korean firms has its roots in the structure of corporate governance.8). 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. The other financial ratios follow the general pattern of the aggregate corporate sector.6). but higher than that of small firms. while their average net profit margin was lower than that of medium firms. The growth performance of large firms for the 1988-1997 period was better than that of medium.5 percent while the aggregate sector recorded only 13. Again. It is notable that the construction sector’s profit rate began its decline in 1995.9). This may be related to its having the lowest DER. However. the average ROE was lowest for large firms. sales of listed firms grew 18.10). However. Performance followed similar patterns across different industries (Table 2. construction. The profit margin of listed firms was generally higher than that of the aggregate corporate sector. the sales growth of listed firms was higher than that of the aggregate sector (see Table 2.Chapter 2: Korea 67 other three economies can be attributed to the emphasis on growth in sales and market shares rather than on profits. and steam supply industry. All sectors experienced a sharp decline in equity and sales growth in 1997.4 percent. both ROA and ROE were lower for the listed firms compared to the latter. In most years. a year ahead of the other industries. with equity in wholesale and retail trade even contracting. Small listed firms were hardest hit by the financial crisis. A comparison of performance by firm size reveals some interesting results. and ROAs of all listed firms declined substantially in 1996 and turned negative in 1997. Net profit margins.
4) 0.0 37.4 10.5 306.2 0.0 22.9 29.3 8.9 0.8 3.1 21.6 1.4 10.0 1.5 5.1 0.1) 0.9 14.6 6.1 20.5 27.1) 3.1 (0.0 2.3 18.3 2.3 25.8 12.4 2.8 461.4 .6 0.1 1.3 1.7 (3.7 1.8 1.0 3.7 5.8 12.0 2.Table 2.0 16.2 6.5 473.7 514.2) 22.0 5.5 432.5) 0.1 16.1 22.1 1.4 17.6) 3.2 25.3 288.9 340.5 (5.1 290.2 423.5 239.5 1.6 16.7 294.5 3.2 12.0 15.5 (1.8 1.7 520.9 31.9) 1.3 8.0 22.0 2.4 10.0) 1.8 34.0 24.0 23.8 32.0 (4.9 10.8 3.7 22.7 7.9 10.0 1.0 254.5 6.8 14.2 18.5 14.9 3.0 1.4 350.2 2.2 0.8 Real Estate.0 1.4 458.5 (0.3 31.7) 2.1 296.0 (0.6 3.9 538.4 (0.9 13.9 428.4 2.4 4.8 10.1 7.3 1.5 1.0 5.8 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 5.5 1.8 526.7 17.9 25.2 16.7 0.2 16.9 2.5 6.2) 15.6 5.5 270.4 2.4 291.8 2.8 345.4 348.9 19.0 7.2) (0.6 12.6 2.4 1.6 655.0 16.2) 6.1 2.4 12.5 13.8 13.7 (0.8 22.9 16.1) (3.0 1. and Business Activities 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 11.1 (0.7 9.0 18.3 15.2 20.1 396.2 0.9 (0.6 1.4 5.5 5.7 228.4 2.9 1.6 12.4 9.9 5.0 22.3 285.0 1.0 2.0) 4.1 10.3 11.5 28.7 4.6 11.2 6.0 12.9 2.5 23.2 5.6 14.8 2.8 16.5 4.8 0.2 20.5 286.8 35.1 1.4 1.6 17.3) (1.2 315.3 8.3 15.3 14.0 21.6 318.3 10.2 36.3 14.7 21.6 24.2 241.6 14.3 2.1 2.8 16.8 17.8 0.1 0.1 0.1 17.9 (0.6 17.8 302.5 Construction 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 18.5 1.1 1.3 13.3 10.2 5.4 10.9 9.8 7. Renting.6 3.4 740.6) (6.4 474.8 24.8 24.8 22.0 18.8 23.4 0.0 15.0 1.5 1.8 2.3 8.1 28.2 (1.0 245.5 19.8 616.5 483.9 16.1 27.4 15.0) 0.4 3.7 30.2 15.4 5.8 562.6 15.9 (0.5 569.6 0.0 9.3 15.4 14.3 11.5 30.0) 0.2 24.3 15.7 317.8 14.4 2.5 338.6 14.8 16.2 7.6 7.8 10.7 16.8) 0.7 10.0 19.4 0.5 16.0 (0.6 375.0 24.9 16.4 5.5 1.
7 2.6 12.0 14.3 (2.0 98.5 14.4 169.3 1.2 698.4 14.2 18.4 15.3 4.0 1.3 543. Gas.0 21.9 3.1 15. Financial Statement Analysis Yearbooks.1) 5.6 6.6 15.2 122.4) (1.0 921.6 34.8 12.3 8.2 11.4 6.4 2.6 9.8) 1.4 9.9 8.4 1.8 6.2 2.7 11.1 8.2 14.7 — — — — — 14.2 7.3 34.3 8.7) (4.8 0.6 4.3) 15.4 367.8 111.8 (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 — — — — — 31.3 23.5 4.2) 9.9 9.4 — — — — — 448.4 12.3 4.7 7.6 14.9 7.1 (11.0 Transport.6 4.9 12.6 512.7 12.5 307. Source: Calculated using data from Bank of Korea.4 1.3 2.4 341.6 1.7 116.7 20.0 1.0 13.7 2.0 106.9 Electricity.3 18.5 47.6 8.4 0.1 4.9 6.6 — — — — — 17.5 12.8 3.2 143.4 30.6 3.4 0.9 332.6 19.1 15.0 1.5 15.1) 1.3 19.2 1.7 11.9 18.4 (0.5 26.6 172.1 2.6 0.3 524.5 612.6 8.4 21.3 740.5 462.6 2.7 0.3 0.9 456.1 6.5 13.6 8.7 0.3 12.3 1.1 17.2 15.1 11.7 11.5 30.4 2.6 6.0 7.8) (12.8 11.4 (2.0 14.2 3.1 3. and Steam Supply 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 12.7 16.4 3.9 4.4 3.5 16.6 9.2 18.8 12.6 19.6 12.5 8.5 (2.1) (0.9 9.5 0.0 2.5 14.2) 0.8 529.1 1.1 12.6 — — — — — 0.5 482.2 — — — — — 2.8 14.4 3.1 323.0) (0.9 4.062.2) 13.9 (11.8 14.8 0.3 112.5 11.5 11.8 4.5 15.8 9.7 187.7 15.8 7.9 12.Table 2.6 9.2 90.4 1.1 16.5 539.8 15.7 510.9 10.6 (2. and Communication 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 15.3 3.0) 1.0 (1.3 17.9 18.4 11.1 11.7) 0.1) (0.6 (2.7 14.9) (8.2 10.6 1.2 10.3) (1.2 14.9 10.0 (15.9 321.9 (10.5 344.3 4.6 20.3) 11.4 7.9 17.2 18.1 21.4 0.0 5.3 — — — — — 10.4 7.6 16.8 3.6 18.7 19. b NPM denotes net profit margin.5 2. a New equity does not include capital surplus.1 14.1 (2.3 9.9 17.9 8.4 12.6 6.8 8. Storage.7 7.5) 22.4 10.4 6.0 89.4 633.3) 4.0) 1.5 117.8 6. .5 14.7 — = not available.0 2.9 1.2 10.3 0.0 5.4 16.1 (0.6 21.4 13.3 125.3 18.1 15.5 14.
8 24.5 ROA 0.4 2.4 1.9 1. II Table 2.8 5. followed by the top 6-10 (Table 2.1 percent of the economy’s total value added (excluding the financial sector).1 6. debts (47. Vol. the largest chaebol. The smallest group had 16 members in 1995.4 22.70 Corporate Governance and Finance in East Asia. It should also be noted that when the financial crisis struck in 1997.6 (1.9 Source: Constructed using data from Korea Investors Service.2 9.0 3. of which 16 were publicly listed (Table 2.0 0.6 and 2.6 1.1 1.5 ROE 3.9 6.3 20.7 1.0 18.2 6. The top five chaebols registered the highest growth rates.3 (0. Hyundai Group. but the number of designated groups has been fixed at 30 since 1993.9 2.4 0. and net profits (46. 1985-1997 (percent.3 15. and close to half of total assets (46.4) 1.9 11.6 3.9 2. the 30 largest chaebols accounted for 13. Performance of Chaebols This section uses available data on the top 30 chaebols.5 5. In 1995.3 4. of Firms 334 351 386 503 626 669 680 681 687 698 715 754 775 Sales Growth 10. the growth of sales of the top 30 chaebols exceeded that of the aggregate corporate sector (compare Tables 2.6 0. The number of Hyundai member companies rose to 57 in 1997. Chaebols have been the most important actors and engines of growth in the Korean economy. sales (45. had 46 member companies.9 Growth and Financial Performance of Listed Companies.7 1.9 percent).7 (5.6 23. 1998. the top 11-30 chaebols experienced a decline of . of which four were listed.1 1. In 1997.9 26.4 1.7 Net Profit Margin 0.9 percent).11).8 0. unless otherwise indicated) Financial Performance Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average No.6 2.3 0.6 22.2 0.9 21.9 0. Between 1993 and 1997.12).8 6.1) 4.5 19.3 percent). Kis-Fas.3 2. it is the chaebols’ large firms that are listed.5 19.4 1. Generally.2 9.2 2.5 0.7) 0.7 percent) of the corporate sector. The criteria for selection of largest chaebols have changed a few times.12).
6 1.2 Note: Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.6 9.8 6.4 2. Others are medium firms.6 0.7 2.3 11.5 3.0 15.8 (5.Table 2.7 2.5 17.2 0.5 Net Profit Margin Year Large Medium Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 2.8 1.4 1.2 (0. Kis-Fas.2 2.9 3.2 10.2 13.5 1.6 3.5 5.2) (1.6 7.4 3.9 14.6 1.4 3.9 0.5 25.8 0.0 16.4 5. 1988-1997 (percent) ROE Large 9.4) 1.0) 0.6) 0.5 2.8) 1.7 (0.5 5.9 1.9 22.0 1.7 18.8) 6.6 (0.9 2.3 9.0 1.9 2.8 17.8 6.0 1.8 0.6 1.1) 5.9 6.6 3.6 8.6 (1.4 1.6 2.3 Medium 14.9 6.5) 1.6 2.3 6.5) 1.6 5.7 (1.0 6.1 2.3 1.4 11.1 2.10 Growth and Financial Performance of Listed Companies by Size.9 0.1 1.2) (1.1 8.6 2.8 3.6 13.9) (6.0 1.9 5.2 3.9 2.0 10.0 4.2 7.6 6.2 2.7 3.5 0. .4 16.2 12.7 (1.2 Small 13.8 0. Source: Korea Investors Service.3 15.0) 1.3) 5.8 10.0 17.9 0.4 6.7 4.3 3.1 0.9 (0.0 (4.9 1.2 1.5 (1. 1998.0 19.3 (0.9 25.8 7.3) 0.6 0.2) 0.4 Medium Small Large Medium Small ROA Growth Performance Large 17.3 15.3 (0.8 16.1 11.2 13.8 0.7 1.
501 13.651 38.129 2.924 2.927 16.996 1.935 2.11 Features of the 30 Largest Chaebols Total Assets (W billion) Name Hyundai Samsung LG Daewoo Sunkyung Ssangyong Hanjin Kia Hanwha Lotte Kumho Doosan Daelim Hanbo Dong-A Halla Hyosung Dongkuk Jinro Kolon Tongyang Hansol Dongbu Kohap Haitai Sammi Hanil Keukdong New Core Byucksan 1995 43.457 14.910 3.398 — 2.574 3.458 6.309 14.117 4.455 22.951 3.690 3. Source: Fair Trade Commission. . of Member Companies 1995 46 55 49 25 32 23 24 16 31 28 27 26 18 21 16 17 16 16 14 19 22 19 24 11 14 8 8 11 18 16 1997 57 80 49 30 46 25 24 28 31 30 26 25 21 — 19 18 18 17 24 24 24 6 8 2 15 — 7 — 18 — No.364 5.346 3.486 6. 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.433 3.177 — 6.475 2.445 4.677 3.743 40.287 10.640 4.427 9.956 3.599 — 2.766 3.423 5.774 7.756 5.Table 2.090 6.313 14.303 3.798 — No.597 351.180 2.995 2.370 6.967 7.929 12.147 5.395 31.761 31.990 2.158 1.158 7.376 35.853 1997 53.246 11.131 3.873 2.
12 Growth and Financial Performance of the 30 Largest Chaebols.3 16. .1) (0.2 0.0 0.5) (0.6 1.3 19.9 1.2 (5.6 (0.4) (14.1 19.0) 3.4 (2.8 27.7 10.5 20.0) 12.4) 1.9 24.1 2.1 (3.2) (0.0 19.4 12.5 32.1 (2.3 11.0 2.2 1.1) 0.0 0.0 17.Table 2.1) 0.2 11.1 (1.5 2.7 10.6 25. 1993-1997 (percent) Growth Rates Year Top 1-5 1993 1994 1995 1996 1997 Top 6-10 1993 1994 1995 1996 1997 Top 11-30 1993 1994 1995 1996 1997 Top 30 1993 1994 1995 1996 1997 Sales 12.2 20.5) (0.6 19.1) (0.6 18.8 Assets 12.4 26.3 1.4 38.3 15.2 (16.7 13.3 0.7 15.2) 1.1 10.3 3.9 3.2) (2.6 4.2 0.3 27.4 0.9 20.2 (2.7 15.4 30.1 27.5 (0.0 31.2 (2.2 3.0 1.0 2.1) (1.3 9.3) 0.0 2.6 Financial Performance Net Profit Margin 1.3 0.7) Source: Bank of Korea.3 14.0) ROA 1.2 0.7 0.8 18.7 4.9 3.9 18.3 1.5 5.5 19.9 20.5) (0.4) (0.7) ROE 5.9 17.0 6.5 27.7 1.8 0.
from 190 to 3. a pyramidal structure of corporate ownership is prevalent.765 percent (Table 2. internal and external control mechanisms. 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. 2.7 percent growth in total assets. Vol.95 percent. weak corporate control. II 2 percent in their sales and a very low 4.5 Founding families are mostly still the largest shareholders and. his/her relatives.74 Corporate Governance and Finance in East Asia. and led to a high concentration of ownership. resulted in the chaebols’ excessive leverage. Their worst year was 1997 when ROE hit -15.” in Korea’s legal and regulatory framework.3 Corporate Ownership and Control This section looks at the key aspects of corporate governance in Korea. In general. the average DER of the 30 largest chaebols reached 519 percent. and government intervention interacted through a set of laws and regulations to bring about the existing structure. and access to credit. Ownership patterns. However.3. technology. However. The ROE of the top 30 chaebols was consistently higher than that of the aggregate corporate sector. The better showing of the top five chaebols was a direct result of their dominance in human resources. The financial performance of the top 11-30 chaebols deteriorated during 1993-1997. and vulnerable balance sheets. By the end of 1997. There has been a wide range in DER among chaebols. 5 While “ownership concentration” can be defined and measured differently in different contexts. it refers to the degree of concentration and shareholdings in the hands of an “identical person. loopholes and inconsistent policies spawned strategic behavior and agency problems.1 Patterns of Corporate Ownership The ownership of most Korean listed firms is highly concentrated. coupled with weak corporate governance. 2. The Commercial Code stipulates the basic governance framework and applies to all corporations. more important. in this instance. and the companies that are under the control of the largest shareholder.13). Only the top five chaebols registered a positive net profit margin in 1997. except for 1995. The absence of a well-developed equity market and the provision of subsidized credit. chaebols had a higher average DER than the corporate sector as a whole. . includes the largest shareholder.” This “identical person. the net profit margin of the aggregate sector exceeded that of the top 30 chaebols.
Samsung 3. Ssangyong 7. Samsung 3. Sunkyung 6.3 315.1 477. Hyundai 2.0 486. Ssangyong 7. Hanjin 8. Doosan 15. Kumho 12. Byucksan 1996 1.3 572.2 423.5 3.1 674. Halla 13.8 312. Kohap 25. Jinro Debt-to-Equity Ratio 376.7 354.5 464.13 The Top 30 Chaebols’ Debt-to-Equity Ratio.764. Dongkuk Steel 19.0 506.2 2. Hanil 28. Jinro 20.5 383. Sammi 27.2 924.7 416.4 192. Tongyang 22.7 620. Kolon 21. Kia 9. Kia 9. Hyosung 18.6 .6 2. Dongah Construction 16. Dongkuk Steel 19. Newcore 30.2 292. Lotte 11.1 3.7 267.9 321. LG 4. LG 4. Hanbo 15.3 328.4 556.2 328.5 337. Hyosung 18. Hansol 17.7 621.2 471.Table 2.4 622.7 688. Kukdong Construction 29.4 205.855. Lotte 11. 1995-1997 (percent) Chaebols 1995 1. Daewoo 5.6 409.5 2. Sunkyung 6.8 313.0 370.6 936.441. Halla 17.5 343.3 297. Doosan 13. Hanjin 8.1 190.8 336. Hanwha 10. Dongbu 24.2 346. Hanwha 10.065.0 436. Daewoo 5.1 385.0 218.6 516.9 751. Haitai 26. Hansol 23. Hyundai 2.4 175.1 278. Kumho 12. Dongah 14. Daelim 16. Daelim 14.244.
9 578.3 347.5 (1.8 307. bBank of Korea.6 478. Anam 27. Shinho 1997 1.8 347. Hanjin 7.5) 404. Tongyang 24. Dongbu 21. Daewoo 4.6 335.5 1.8 399. Hanil 28. Haitai 25.7 1. Dongbu 23.13 (Cont’d) Chaebols 20.600.9 216. Kamgwon Industrial 30.0 505.6 Sources: aFair Trade Commission.784.5 386. Saehan Average of All Chaebolsa 1995 1996 1997 Average of All Industries Excluding Financial Sectorb 1995 1996 1997 Debt-to-Equity Ratio 317.5 519.498.3 676. Dongah 11.8 468.1 359.5 576.0 907. Kumho 10.3 1. Lotte 12. Samsung 3. Keopyong 29.8 658. Hansol 16. Keopyong 29.1 472. SK 6. Financial Statement Analysis Yearbook. Kohab 18. Hyundai 2.8 647.9 465.4) 513.3 399. Newcore 28.225. Kolon 19. Hanwha 9. Daesang 27.0 305.6 590.501. Newcore 26.9 1.7 944.1 438. Tongyang 24.5 323. . Shinho 26.6 416. Halla 13. Anam 22. Doosan 15. Kohab 22. Haitai 25. Jinro 23.Table 2.214.7 370.1 433. Kolon 21.6 424.9 490.5 (893.9 472. Ssangyong 8. LG 5. Dongkuk Steel 20.4 1. Hyosung 17.1 375.5 261.8 590. Miwon 30.0 419. Daelim 14.8 338.
The next important group was “other corporations. The reduction can be . However. The holdings of financial institutions. i.14). resorting to extensive use of pyramiding to maintain control. including banks and other financial firms. individuals were also the largest shareholder group. including investment trust companies. the ownership structure can bring about an incentive effect. The percentage of shares owned by “other corporations. fluctuated widely during the period. Financial institutions owned as much as 28 percent of the total corporate shareholdings in 1992.” followed by banks. the entrenchment effect outweighs the incentive effect. the percentage of holdings by individuals slipped to 60.7 percent by 1997. the year the stock market was in a frenzy due to buying sprees. the Government. with a given range of managerial shareholdings (for instance. From 69.Chapter 2: Korea 77 When controlling shareholders hold a very small percentage of the shares. 10 to 30 percent).e.6 percent by 1997. Theoretically. Composition of Ownership Among listed companies. Thus. an increase in their ownership may bring their ownership incentives to converge with those of the minority shareholders. while those owned by banks. an entrenched manager is insulated from market pressure and can pursue personal goals without the fear of being replaced. Among listed nonfinancial companies. the extent of ownership by these individuals declined gradually after 1988. and insurance companies increased during the period. Beyond that range. but their shares declined to 21.. When managerial holdings are reinforced by artificial control mechanisms such as pyramiding. However. that is.1 percent. the entrenchment effect and problems of agency may be more pronounced in chaebols than in independent firms. The pattern of distribution changed little through 1992-1997.” foreigners. and state-owned companies and securities companies declined. the incentive effect once again dominates. large ownership can also bring about the entrenchment effect. Securities companies reduced their holdings over this period of falling stock prices as the size of investment trust companies’ stock portfolios declined. managerial entrenchment becomes more likely. Most non-chaebol listed firms in Korea are believed to have ownership concentrations within the 10-30 percent range. the individual owners—the portfolio investors as well as the controlling shareholders and their family members—formed the largest shareholder group (Table 2. The controlling shareholders of chaebols hold comparatively smaller percentages of shares. and then steadily declined after 1993.
9 2. d Constructed from data files of the Korea Listed Companies Association.5 1989 498 0.2 5.6 Year No.5 60.6 12.4 13.9 1. investment trust companies.1 8.1 4.3 8.6 1991 505 0.2 1993 511 2.1 18.3 1.2 B.8 59.6 16.2 3.6 36.1 21.2 18. etc. a The State covers the Government and state-owned companies.9 19.0 28.1 11.7 1990 531 0.8 5.3 5.9 17.4 34.b A.8 4. mutual savings.8 5. and finance companies.5 12.9 37.9 4.8 2. Listed Nonfinancial Companiesd 1988 406 0.3 2.7 9.1 2.1 17.8 1995 548 2.6 8.7 8.4 Insurance Firms Other Corporations Foreigners Individuals 39.0 4.2 7.5 1.4 6.5 4.2 1. All Listed Companiesc 1992 681 1993 687 1994 698 1995 715 1996 754 1997 775 9.5 7.7 9.3 18.9 1.1 8.9 26.6 16.9 5.4 14.Table 2.4 5. .3 18.” includes commercial banks.6 2.8 69.7 4.1 18.5 Note: Ownership is based on number of shares.6 22.4 13.7 3.4 18.1 21.7 14.3 26.3 1996 570 2.0 59. of Firms The Statea Banks.5 6.0 60.1 10.2 8.7 6.3 1994 521 1.2 9. b “Banks.9 15.9 36.0 5.2 17. 1988-1997 (percent) Financial Institutions Securities Firms Total 28.4 1997 551 1.7 18.0 7.6 20.2 8.1 1.5 1.5 16.7 7.5 62.3 1.2 4.0 27.5 18.5 7.3 39.8 17.8 17.6 19.0 5. etc.3 17.4 5.14 Ownership Composition of Listed Companies.2 2.1 3.2 9.8 59.6 9.7 59.6 13.6 16.5 1992 508 2.5 6.2 5.6 9.0 9.0 8.1 68. c Data from Korea Stock Exchange.9 2.3 5.3 17.1 60.8 2. merchant banks.
18).Chapter 2: Korea 79 ascribed to prudence in staying away from the stock market—as part of their risk management strategy—as the stock market was in doldrums throughout the 1990s. and small companies. However. Foreigners gradually increased their equity shares in 1992 when direct purchases by them were first permitted. The Government’s and state-owned institutions’ (including some banks) ownership was generally small except in the power sector. of some banks. indicating their increased investments particularly in the service industries with high growth rates. electricity. 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. In most instances. and US (Table 2. there appears to be no significant difference in the overall shareholding patterns between the two groups (Table 2. When independent companies are distinguished from firms affiliated with the 30 largest chaebols. This is low compared with those in Japan. Over the years. government ownership in nonfinancial companies was remarkably smaller and more concentrated. indicating their heavier reliance on inter-firm financing investments.15).8 percent of listed shares in 1997. Individuals held the majority of the shares in all industries except in telecommunications. held 26. UK. One minor difference is that the percentage of shareholdings by corporations is slightly higher in large-sized firms. with the Government continuing to hold a sizable share in the Korea Electric Power Corporation. and service of motor vehicles (Table 2. The ownership distribution in listed nonfinancial firms. Institutional investors. financial institutions had more shares in the manufacturing sector than in primary industries. Before such liberalization. In general. the Government was the sole owner. medium. However. did not vary significantly (Table 2. whether partial or absolute. foreign holdings were derived from purchases through country funds and direct capital investments.17). other corporations’ holdings shifted toward service industries. This trend can be explained by government ownership. the Government acquired an even bigger share in several banks as part of its program to bail out these distressed institutions. the holdings of institutional investors were expected to increase significantly with the Government’s introduction of US-type investment companies in 1998 and . as distinguished from individual and foreign investors. In 1998.16). The holdings of other corporations are mainly equity investments in affiliate companies. Compared with its holdings in all listed companies. Corporate holdings averaged 16 percent throughout 1988-1997. categorized into large.
2 22.7 2.9 66.4 2.9 42.7 64.2 0.3 7.2 9.2 9.7 14.4 8.3 62.1 1.8 7.2 0.0 9.5 3.4 1.9 23.1 8.0 1.7 29.4 0.5 0.7 14.2 7.4 8.8 73.9 52.0 9.9 59.2 0.2 2. and Printing Pulp.2 54.8 7.7 20.6 3.3 0. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.5 85.6 5.5 12.7 20.6 18. Gas.5 0. and Printing Chemicals.8 6.0 10.0 — 39.1 88.5 — — 0.7 17.1 65.9 16.b Securities Firms Insurance Firms Other Corporations Foreigners — — 0.4 56.3 13.2 — 0.2 — — 0.5 0.9 55.5 — 0.7 22.4 — 0.4 7.8 5. Motor Vehicles Electricity.3 38.5 4. Etc. Elecl Mach.4 1.9 1.3 2.7 63.1 0.5 17.3 57.6 — — 2.9 15. and App. and Steam Supply Precision and Optical Instruments Other Manufacturing Construction Service of Motor Vehicles Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Average .6 1.2 9.9 0.2 1.3 2.7 2.8 3.8 7.4 5.7 59.1 0.3 0.4 8. Paper. Rubber.7 22.3 6.7 2.1 0.9 1.0 — 0.1 8.6 24.8 1.4 Banks.2 1.1 10.0 2.0 0.9 4.1 7.Table 2.4 14.8 Individuals 83.2 0.5 6. 1990 and 1997 (percent) Financial Institutions The Statea — — 0.2 17.9 60.8 3.15 Ownership Composition of Listed Nonfinancial Firms by Industry.0 20.1 27.3 9.8 7.3 4.7 6.1 0.0 7.3 1.0 9.3 0.8 7.5 19.0 8.3 1.9 19.9 8..9 10.0 Industry 1990 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.4 56.1 4.5 7.8 8.7 1.1 19.6 11.4 62.6 8.2 64.3 11. Paper.5 — 1.3 10.5 0.0 9.
7 5.0 6.9 2.3 8.9 57.2 0.1 54.3 7.4 2.6 0.0 5.4 9.8 54.1 25.1 6. and finance companies.3 1.8 2. etc.9 2.9 5.1 2.9 1.8 0.0 11.7 23.2 1.2 4.4 58.4 0.6 2.9 7.3 15.9 1. a The State covers the government and state-owned companies.6 2.5 0.0 8.1 1.6 5.4 1.2 0.8 4.3 1.2 5.5 1.6 7.9 1.6 60. Motor Vehicles Electricity.2 13.1 9.0 1.1 — 1. Paper.9 2.1 2.2 5. Source: Constructed from data files of the Korea Listed Companies Association.8 57.9 7.6 59.1 — 0.8 2.9 6.1 1.4 16.9 69.2 23. Elecl Mach.4 6.7 4.8 27.4 20.7 2.7 2.3 31.7 17. and Printing Chemicals.7 2. and App.5 3.9 5.4 1.5 3.2 7. merchant banks.4 76.3 2.4 2.1 9.4 68.6 18.5 — 2.6 6. Gas. Paper.8 0.6 0.9 18. Rubber.7 2.4 1. mutual savings.0 6.5 63.8 6.2 6.9 0.2 4.3 60. investment trust companies.4 45.5 12.8 2.” includes commercial banks.9 78.0 43.8 5.3 65.1 3.4 2.2 8.0 7.4 — 1.0 60.9 20.8 11.5 3.5 7.3 0.9 6.6 3.8 3.6 20.5 59.1 3.6 75.1 4.5 5.7 19.4 4.2 4. b “Banks. .6 6.2 49.4 43.8 12.0 3.4 3. Note: Ownership is based on number of shares.7 6.4 58.4 4.8 5.3 57.9 2.6 2.2 3. and Printing Pulp.78 81.0 4. and Steam Supply Precision and Optical Instruments Other Manufacturing Construction Service of Motor Vehicles Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Average 1.6 1.7 1.5 4.5 4.6 14. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.6 — = not available.2 1.3 6.5 6.9 20.1 18.3 6.1997 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.5 3.2 4.
merchant banks.1 2.1 Banks. etc.5 16.5 18.7 Foreigners 4.4 1.5 2.1 6.0 1. investment trust companies.8 6. Others are medium firms.9 4. etc.0 Other Corporations 16.8 1. of Firms Large Medium Small Total 211 208 80 499 a Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.4 61.0 6.4 4.5 Individuals 60.7 0.6 60.c Securities Firms Insurance Firms Other Corporations Individuals 58.4 2.9 5.4 17. 1997 (percent) The Stateb Foreigners 4.Table 2. and finance companies. Securities Firms Insurance Firms 2.4 Firm Sizea No. c “Banks.5 6. of Firms Independent Firms Affiliates of 30 Largest Chaebols Total 316 117 433 Source: Constructed from data files of the Korea Listed Companies Association. Source: Constructed from data files of the Korea Listed Companies Association.7 Control Type No.3 6. mutual savings.8 60.8 4. etc.7 4.5 4.3 Banks.4 5. 1997 (percent) The State 1.4 21.2 1.16 Ownership Composition of Listed Nonfinancial Firms by Size.7 8.5 8.5 19. .9 2.5 62. b Table 2. The State covers the government and state-owned companies.8 2.” includes commercial banks.7 6.7 1.4 61.8 3.1 8.4 2.4 5.6 16.17 Ownership Composition of Listed Nonfinancial Firms by Control Type.8 4.
This has had profound implications for corporate governance and the market for corporate control in Korea. and other shareholders who do not belong to either the minority shareholders or the majority shareholder group. Institutional Investors 42.19).4 26. 1997 (percent) Country Japan Korea Taipei. his/her family members. rather than the individual.8 10.1 financial institutions’ establishment of corporate pension fund accounts. The majority shareholder group’s shareholdings in listed nonfinancial firms steadily declined from 1990 to 1996.China United Kingdom United States Source: Stock Exchange of Korea.6 39. Generally.8 9.18 Ownership Composition of Listed Firms in Selected Countries.3 54.7 16. while family members accounted for only 30 percent. investors (Table 2. 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. At the moment. and the companies under the control of the largest shareholder. Foreign holdings of Korean shares were 9. the majority shareholder group on average held 23-30 percent of outstanding shares in the period 19881997 (Table 2. minority shareholders.6 Foreigners 9. the majority shareholder group in all listed companies consists of the corporate. including those of the largest shareholder.1 percent and appear to be similar to the proportion of foreign holdings in the four other countries.8 56.6 Individuals 23.1 8.5 20. corporations held 70 percent of the controlling blocks of shares. But these may . Among nonfinancial listed firms.3 6. only closed-end investment companies and traditional investment trust companies are allowed.20). Concentration of Ownership The analysis of ownership concentration in this section focuses on shareholdings of the majority shareholder.5 45.3 47. defined as those holding less than 1 percent of shares. In 1997. for example.Chapter 2: Korea 83 Table 2.
9 3.8 72. .1 28.8 Individual Subtotal Other Shareholders Corporation 3.2 2.5 43.6 5.9 33.1 4.0 4.0 1.7 18.19 Ownership Concentration of All Listed Firms.1 23.1 37.0 66.7 16.7 7.8 73. Other shareholders are those who do not belong to either the minority shareholders or the majority shareholder group.7 Note: The majority shareholder includes the largest shareholder.0 2.1 5.4 5.9 6. Minority shareholders are those holding less than 1 percent of shares.0 22.6 22.3 30.9 32.8 8.0 Year Corporation Individual 1992 1993 1994 1995 1996 1997 41. Source: Stock Exchange of Korea.7 44.0 69.3 18. and the companies under the control of the largest shareholder.9 2.6 46.9 Individual 2.6 2. his/her family members.1 5.4 3.3 2.0 29.Table 2.6 73.6 26.7 6.2 Minority Shareholders Subtotal 71.1 14.3 Subtotal 5.0 25.1 21.2 26.2 2.1 32.4 7.9 7. 1992-1997 (percent) Majority Shareholders Corporation 15.1 15.
21]). in the small firms. rubber and plastics. Majority ownership is also high in the chemicals. 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.6 11. 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. Besides.8 28.8 57. thereafter. It was highest in medium-sized firms before 1993 and.6 57.6 58. Across industry.9 Other Shareholders 18.2 15. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Minority Shareholders 53. the majority owner held more than 20 percent of an average firm.22).9 25.5 13. the Government has retained a large number of shares. Meanwhile.8 54.1 50.8 12.Chapter 2: Korea 85 Table 2. The shareholders that held more than 1 percent but did not belong to the majority group held about 20 percent on average.7 18. minority shareholders.4 28. .9 12. and mining categories.3 25. 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 2.0 58.8 Majority Shareholders 27.5 60. In such cases.0 22. In telecommunications.9 29.3 62.0 20. collectively owned less than 50 percent of an average firm.8 25. which held less than 1 percent of a company’s outstanding shares as of 1997.20 Ownership Concentration of Listed Nonfinancial Firms.5 12.4 23.4 Source: Constructed from data files of the Korea Listed Companies Association. ownership was relatively diffused due to government regulation.9 48.9 27. In most industries. hiding shares offers no additional tax or other benefits. Ownership concentration tended to be lower in large compared to medium and small listed firms. The practice of hidden shares seems to have been less prevalent in recent years.5 23.
7 24.8 24. and Plastics Basic Metal Fabricated Metal and Machinery Electronics.5 52.1 43.6 34.4 11.0 39.2 46. 1997 (percent) Number of Firms 3 2 43 49 12 16 90 39 31 71 34 8 9 49 40 15 1 10 29 551 36.21 Ownership Concentration of Listed Nonfinancial Firms by Industry.2 34.8 41.0 54.3 26.5 44.2 23.2 22.9 Minority Shareholders Majority Shareholders Other Shareholders 12. Paper.6 19. .7 26.9 10.0 21.8 25.7 29. Motor Vehicles Electricity.8 21. and Printing Pulp.5 20.5 19. Paper.6 50. Elecl Mach.6 53.5 47. and Steam Supply Other Manufacturing Construction Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Total Source: Constructed from data files of Korea Listed Companies Association.4 53.5 23.7 17.8 51. Gas.5 21. and App..3 39.2 26. Rubber.6 25.3 19.5 41.0 30.4 Industry Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.5 16.2 20.7 36.6 38.1 49.7 21.Table 2.0 51.1 19.2 19.2 37.8 44.7 27. and Printing Chemicals.1 17.8 29.8 55.9 26.9 44.8 31.2 48.4 16.
7 16.6 15.9 26.2 32.2 56.2 18.9 21.5 26.2 50.6 24.6 27. .9 28.4 30.6 59.5 19.0 66.7 15.2 Majority Shareholders 26.7 17.5 27.9 16.1 15.3 55.4 21.2 12.5 12.8 28.5 21.6 62.0 26.9 56.8 11.1 16.9 12.9 17.5 51.6 11.6 31.7 14.5 10.9 55.4 29.9 23.3 19.4 30.8 62.8 52.4 47.3 26.8 27.2 26.7 28.3 25.8 17.1 27.5 28.5 Other Shareholders 19.2 11.7 31.5 19.7 57.9 22.7 57.5 49.6 55.4 30. 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 53.22 Ownership Concentration of Listed Nonfinancial Firms by Firm Size.6 65.Table 2.8 56.7 22.8 50.1 58.5 12.1 20.0 24.9 53.0 55.0 59.2 21.3 27.2 21.2 52.4 51.8 52. 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.1 48.5 33.3 21.2 55.2 21.2 Source: Korea Listed Companies Association.9 60.
Shleifer. thus a firm destroys value. Kim (1992) and Kim. if TQ is lower than 1. J. II Ownership Concentration and Financial Performance J. one company can still place equity investments in another. although turning points in the value of firms are different. The pattern of the relationship between SCS and TQ is similar between Korean and US firms (Mork. This type of inter-firm investment. If TQ is higher than 1. and the shareholding of a controlling shareholder (SCS) as the degree of ownership concentration. Kim (1992) found the relation between TQ and SCS to be nonlinear. If SCS is below the range of 20-25 percent. TQ was calculated by dividing the market value of a firm by the substitution price of its assets. TQ increases as the SCS increases. The relationship between TQ and SCS shows a similar pattern. Hong. Where direct cross-shareholding is not allowed. If SCS reaches 10 percent. TQ has a maximum value. it means the firm creates value. If SCS is above 20-25 percent. Then TQ declines until SCS reaches 45 percent and increases until it reaches 50 percent.88 Corporate Governance and Finance in East Asia. Vol. H. which is the company holding more than 40 percent of outstanding shares of its subsidiary. affiliated companies have been able to conduct inter-firm transactions. and Kim (1995) studied the empirical relationship between the degree of ownership concentration and financial performance in Korea. They analyzed firms in which controlling shareholders participate as managers. which can then pass the equity capital to a third. is effective control of a certain group of companies even with a smaller investment. and Kim (1995) reached a similar conclusion. The Code prohibits a subsidiary company from owning shares of its parent company. This refers to the situation wherein Company A holds shares of Company B and simultaneously Company B holds shares of Company A. If SCS is below 10 percent. often at terms unfair to one of the transacting parties. thus a firm creates value. H. from the standpoint of the controlling shareholder. 1988). In Korea. one company from a chaebol group could obtain debt payment . TQ is above 1. For example. the firm destroys value. The study by Kim. and Vishny. TQ is below 1. Hong. called “pyramiding”— commonly (though incorrectly) known as “indirect cross-shareholding”— is prevalent in Korea. Both studies used Tobin’s Q (TQ) for the value of a firm as an index of financial performance. Inter-Firm Investments and Pyramiding in Chaebols The Commercial Code imposes limits on direct cross-shareholding. One of the merits of pyramiding.
neither the investors nor the relevant government authorities were active in monitoring such unfair dealings between firms. dominated the majority shareholder group in chaebol-affiliated companies is consistent with the results of the ADB survey conducted for this study. together having a total of 292 domestic subsidiaries. the average shareholding of the controlling owners and their families was 8. Twenty-two of the 81 respondents were independent. 53 percent were domestic nonfinancial firms. together owning an average of 38. not individuals. or about five subsidiaries each. Thus. This also partly explains why chaebols frequently opted to expand by establishing new firms rather than placing investments internally. Among the subsidiaries or firms receiving investments. or an average of 13 firms per company. for example.5 corporations and two individuals. Among chaebol affiliated firms. In many instances. Thus. The extent of pyramiding can be seen in some of the previous tables. For the whole sample. Until recently. In the case of the 30 largest chaebols. corporations hold about 20 percent of the outstanding shares of all listed nonfinancial firms. But the controlling power of the owners also stems from inter-company shareholdings of the subsidiaries. and 319 foreign subsidiaries. If we define the internal shareholdings of a . Among the 81 listed firms in the ADB survey. the top five shareholders consisted of 2.23.14. or about four firms each. there are instances of direct cross-shareholding in Korean firms.9 percent of shares.5 percent. Only six firms (or 13 percent) indicated that their subsidiaries also owned shares in themselves. 62 percent (16 out of 26) had a corporation as the largest shareholder. 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. In Table 2. financial institutions that are subsidiaries of a chaebol also hold shares in its member firms. the top 30 chaebols’ shareholding by subsidiaries was 34. 59 were parent firms with one or more subsidiaries. although they are likely to be insignificant. 59 parent companies collectively had investments in 759 firms.4 corporations.5 percent as of 1997. firms linked through partial equity investments could enjoy the advantage of consolidation without an actual formal consolidation or merger of operations taking place. For the same year. together owning an average of 37. Of the 81 respondents. The fact that corporations. standalone setups. The top five shareholders of the chaebol-affiliated firms consisted of one individual and 3.Chapter 2: Korea 89 guarantees from other members of the group at no cost.5 percent of shares. Partial results are shown in Table 2. 34 percent were foreign companies. and about 11 percent were domestic financial institutions.
4 42.Table 2.1 3.8 18.5 4.4 1.9 21.4 38.1 22.5 31.7 37.7 5.9 5.0 1.23 Ownership Concentration in the Survey Sample of 81 Listed Firms. a Number of shareholders.3 12.2 37.5 2.0 13.8 31. .8 8.9 34.6 3.6 16. b The chaebol affiliated firms are those belonging to one of the 30 largest groups.4 25. of Firms Largest Shareholder’s Holdings (%) Compositiona Individuals Firms Shareholdings (%) Individuals Firms Total Classification Total Sample Non-Chaebol Affiliated Largest Shareholder is Largest Shareholder is Largest Shareholder is Chaebol Affiliatedb Largest Shareholder is Largest Shareholder is Largest Shareholder is CEO an Individual a Firm CEO an Individual a Firm 81 55 31 10 14 26 3 7 16 20.0 17. A few companies reported less than five largest shareholders.4 21.5 38.5 18.4 18.0 3.6 3.3 26.2 25.0 2.4 2.4 11.9 29.0 3.7 19.5 1.5 2.5 24.7 39.5 2.8 Note: The survey was conducted during the period January through May 1999 and included nonfinancial listed firms only.1 1.0 21. 1999 Five Largest Shareholders No.6 34.5 2.8 38.6 3.5 4.0 1.7 0.8 37.
6 33. 6 7 Hattori. C. Many attempts have been made by researchers to identify the typical patterns of ownership structures in chaebols. Table 2.5 percent.2 12. 79-95.4 1993 43. 1989.7 1992 46. the controlling families owned 8.6 Later studies by Lee (1997) and Lim (1998)7 find similar patterns. Tamio. 1997. Chung and H.1 1997 43. it appears that the chaebol families have had a strong desire to expand their business bases. 1987-1997 Type of Shareholding Internal Shareholdings Family Member Companies Source: Korea Fair Trade Commission. 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.” Paper presented at the Annual Conference of Financial Management Association. Chicago.24 Internal Shareholdings of the 30 Largest Chaebols.5 34. edited by K. 34. “Japanese Zaibatsu and Korean Chaebols. H.8 33. Internal shareholdings in some chaebols also include shares owned by nonprofit organizations operated by the controlling family.2 1994 42.7 31.4 1990 45. Jae Woo. 15 October 1998. the average internal shareholding ratio of the top 30 chaebols was at least 43 percent.5 percent and member companies. 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.Chapter 2: Korea 91 chaebol as the shareholdings of the controlling family and the member companies of the group. As of 1997.7 9.” In Korean Managerial Dynamics. Table 2.4 13. pp. 1987 56. . Ungki Lim. Lee.0 8. Hattori (1989) identified three patterns based on data in the early 1980s.8 40. New York: Praeger. “The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols. Family holdings include shares owned by the family members and by parties considered to be under the influence of the family. 1998. The family and member companies’ shareholdings have been declining over time. Based on these studies. the ownership patterns can be described as follows. Lee.4 10. “Is the Fair Trade Policy Fair?” Korea Economic Research Institute.24 shows the average internal shareholdings in the 30 largest chaebols.2 15.2 33.5 Judging from the historical record.
The Hanwha Group can be classified as such a company.” Here the family directly controls a base company and a nonprofit foundation. Its controlling family holds shares in three base companies through which they exercise control over the other member firms. investments made by the base companies. The controlling family has sizable investments in two base companies and smaller investments in many others. Chaebol Reforms Various measures have been taken to improve the transparency of chaebols with regard to accounting. Also.” shows a simple pyramidal structure. the family controls the group’s member companies by its own shareholdings. But the former chief executive officer (CEO). and business activities. holdings of the nonprofit foundation.” Under this type of ownership pattern. and subsidiaries’ equity participation. Vol. Thus. The two base companies have investments in three other base companies. Investments between the lower level subsidiaries are rare. The family itself holds shares in some subsidiaries. which in turn hold shares in some of the other subsidiaries. financial. The Hanjin Group. completely dissolved under financial distress. The third (Type C) is “indirect control via complex shareholding. II The first (Type A) is called “direct family ownership. there is no controlling shareholder. Sun Hong Kim. A nonprofit foundation under the family’s control is the largest shareholder of one of the base companies. As of 1997. which then make investments in the subsidiaries. Hyundai Motors acquired Kia Motors via an international auction. or merged into. One of the . Here the family is the controlling shareholder of one or more strategic base companies that have enough equity participation in the subsidiaries. The second (Type B). consisting of eight listed and 16 privately held firms as of 1997. called the “indirect control via base company. It consists of seven listed and 24 privately held firms. For example.92 Corporate Governance and Finance in East Asia. The fourth type (Type D) is “management control. and his management team exercised full control over the group without much interference from major investors. The Hyundai Group exemplifies this. other firms. Kia Motors was the base company and had such strategic shareholders as Ford Motors of the US and Mazda of Japan.” A family owns a substantial portion of shares of member firms and becomes the controlling shareholder of each. The Kia Group was about the only management-controlled group but was out of existence by 1999. subsidiaries have extensive investments in other subsidiaries. Most of its member firms were acquired by. it had 18 listed and 39 private companies. is an example of this type.
The Government is also considering whether to allow consolidated taxation for pure holding companies. Also.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. the Credit Management Regulation rules were amended to prohibit financial institutions from requiring guarantees from affiliated firms when extending new loans. An operating holding company is defined by the Fair Trade Act as one whose investment in others does not exceed 50 percent of its total assets. Initially. the act did not have any important provisions except the standard clauses prohibiting monopolization of an industry through business combinations. These conditions are aimed at restricting excessive pyramiding and expansion of chaebols. A third disallows multiple layering of holding companies. Another is that the holding company should own more than 50 percent of the shares of a nonlisted subsidiary company and more than 30 percent of a listed company. The first serious attempt to deal with this issue was the introduction of the Monopoly Regulation and Fair Trade Act of 1980 (hereinafter. This limit was also applicable to banks and insurance companies. following the amendment of the law. The Fair Trade Act was also revised in February 1998 to prohibit cross-guarantees of debt among members of a chaebol. there are reports that some top chaebols are studying the feasibility of transforming their organizational structure. One condition requires that the DER of the holding company should not exceed 100 percent. Cross-guarantees are believed to constitute a form of wealth transfer from financially strong members to weak ones. bankruptcy reorganization. At this early stage. Existing guarantees had to be resolved by March 2000. the Fair Trade Act). thus hurting the shareholders of stronger firms. This was the reason why chaebols chose to employ pyramidal structures. However. The prohibition of holding companies was also abolished in 1999. It remains to be seen whether they will adopt the holding company structure in the future. . The limit on investments was reduced to 25 percent in 1994 and completely eliminated by 1997. Until the end of 1998. only operating holding companies were allowed to be established. They hindered early exits (liquidation. These amendments prohibited holding companies and direct cross-shareholding. 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. The Fair Trade Act was amended in 1998 to allow pure holding companies to be established under restrictive conditions.
chaebols dismantled their “planning and coordination offices” or “chairman’s offices” under pressure from the Government. even though they were legally independent with their own board of directors and the outside shareholder groups were not identical. and transferred funds generated by one firm to another. Some chaebols have disintegrated or shrunk in size. The staff of these organizations were employees of member firms. The office established strategies for the group as a whole. Their operating costs were borne by the member companies rather than by the controlling shareholder. who is universally called the “group chairman. It also acted as the secretariat for the unofficial “presidential meeting” of the member firm presidents.) 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. II etc. planned for capital raising and allocation on a groupwide basis. the Commission has strengthened its investigative activities to eradicate cross-subsidization and wealth transfer activities among group members. Chaebols maintain that the restructuring headquarters will exist only for a limited period. 2. until urgent restructuring is complete. but the larger and stronger ones still operate their newly named “restructuring headquarters” under the control of the group chairperson.2 Internal Management and Control Monitoring of corporate management by shareholders. usually in the rank of a company president.94 Corporate Governance and Finance in East Asia. there have been no significant changes. Some chaebols operated “group management boards” attended by top executives (presidents or chairpersons) of larger member firms. Since the economic crisis. unlike the regular consolidated statements that only cover those firms that are related through direct equity participation. These offices were legally informal and functioned as the headquarters of chaebols. Despite chaebols’ decision to dismantle the chairman’s offices. In 1998. Vol. and the capital market was almost nonexistent until the recent reform . The 30 largest chaebols are now required to publish “combined” financial statements. boards of directors. which put together the accounts of all members of a chaebol. The chairman’s office had its own chief executive officer.3.” The group chairman operated through these offices and treated the individual member firms as if they were the divisions of a single legal entity. 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 some large ones have two or more. This policy managed to hamper any monitoring initiatives from the capital market. However. This implies that the typical agency problems in Korean corporations stem from conflicts of interest between inside (the largest) and outside (minority) shareholders. corporations should have a board of directors consisting of at least three 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. Loan agreements and debt indentures did not include strict covenants. in most Korean firms. as the major creditors. With few exceptions. this was complicated by the prevailing attitude that large companies. he or she generally approves major decisions made by the management. and takeover codes were not accommodative to active monitoring. Even when the covenants were violated. Meanwhile. were too big to fail. Thus. especially chaebols. control is not separate from ownership. Legal provisions to protect investors were limited. Directors are elected at the general shareholders meeting for a term not exceeding three years. Professionalism in management was not well developed and managers were content with receiving orders from controlling shareholders. the creditors did not declare defaults. the controlling shareholder is officially the representative director and the CEO. The board elects one or more representative directors from among the board members. Board of Directors General Characteristics of the Boards Under the Commercial Code. Under such circumstances. Even where the largest shareholder is not the representative director. . or at least acts as the de facto CEO. As of 1997. In most listed companies. the representative director was also the chairperson of the board.Chapter 2: Korea 95 efforts. There are many reasons for this. had their own governance problems. creditors were not active in monitoring debtor firms and relied mainly on guarantees and collateral. except for banks. the controlling shareholder (or a member of the controlling group) was the legally registered representative director in 354 out of 551 nonfinancial listed firms. Banks. the concept of fiduciary duty of managers was not well established. only the Government could play an effective role in monitoring corporations. Most companies have one representative director.
all of whom were managers.96 Corporate Governance and Finance in East Asia. 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. members of the board. and their positions (accept or reject) on matters voted on in board meetings. Most of the outside directors in those days were the controlling shareholders of chaebols or executives of affiliated companies. 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. Recent Reform Efforts on the Board System In 1997. were supposed to be outside directors. almost all companies succeeded in adopting cumulative voting. there is concern that newly elected outside directors still lack independence from the management or the controlling shareholder. companies have to disclose in their annual reports the frequency of board meetings. 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. 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. In order to address this concern. cumulative voting is not mandatory and a company can exclude itself from its application by amending its charter. However. With the boards consisting only of insiders. the attendance rate of outside directors. Despite the qualification requirements. Further. 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 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. other than the representative director(s). The Commercial Code was also revised in 1998 to introduce cumulative voting for the election of directors. In the 1999 annual shareholders meetings. Moreover. A few large companies had more than 50 directors. . However. 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. II When the Commercial Code first introduced the corporate board system in the 1960s. Vol.
Directors were also chosen on the basis of their relationship with the controlling . the Korean Code recommends that large listed firms should have at least three independent directors. the OECD principles of corporate governance were the minimum standard for the Korean Code of Best Practice. having no controlling shareholders.Chapter 2: Korea 97 The committee structure of the board as found in the US has not yet been adopted by listed companies.4 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. In March 1999. The controlling shareholder of some banks is the Government. 88 percent had plans to hold elections in the near future.9 percent on average. In 78 percent of the responding firms. Directors were most frequently elected because of their professional expertise (74 percent of the respondents marked this answer).1 percent of outstanding shares of a listed company. The Commercial Code is being amended to allow a choice between the audit committee system and the current internal auditor system. the chairperson of the board was also the CEO and on average held 10. Almost all (92 percent) of the respondents had one or more outside directors and 70 percent were elected after the Asian financial crisis. although some banks recently have established board committees. ADB Survey Results on Boards The ADB survey results confirm the above assessments and provide early indications on the effects of the reforms. Among the firms with no outside directors. Where the chairperson was not the CEO. this committee adopted the Code of Best Practice in Corporate Governance. Where the two were separate. which had extended financial support in their recent recapitalization efforts.1 percent and outside directors 1. was established under the auspices of the Ministry of Finance and Economy and the Korea Stock Exchange. the Corporate Governance Reform Committee. In September of the same year. This is because most banks. an audit committee. These results are in accordance with the new listing rules introduced in 1998. a blue-ribbon committee. they had a parent/child relationship in 20 percent of the cases. inside directors owned 16. are required to have a majority of outside directors. who would comprise at least 50 percent of the boards.5 percent of the shares. and a nominating committee. he or she held 6. Among others. Meanwhile.2 percent and the CEO 14. The average board had 8. On average.
In 13 percent. In a very small number of firms. The board or the management then determines compensation packages for individual directors. the term of appointment of directors and board chairpersons is three years. Most frequently. The current chairperson has been in office for 6. These were established only recently. 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). in some firms. election of directors was based on shareholdings (7 percent) and status as founder (7 percent). However. the management determines the remuneration. In most firms. Members of controlling shareholder families or their trusted company personnel often act as directors for multiple chaebol firm boards. the board had no committees.2 years on average. The reason for this high frequency of interlocking directorship is that many listed firms belong to chaebols. relationship with controlling shareholders (21 percent). the management nominated director candidates (64 percent of the directors). Remuneration for chairpersons include only fixed fees in 76 percent of the sample firms. one person was sitting on nine boards and this person was the CEO of a chaebol firm.98 Corporate Governance and Finance in East Asia. among the 81 sample firms. The survey results indicate that boards determine remuneration packages for chairpersons in 42 percent of the firms. Chairpersons of the board were elected on the basis of professional expertise (33 percent of the firms). Less frequently. This rather long tenure must be due to their status as controlling shareholders in most firms. . In some instances. Some directors were nominated by significant shareholders (18 percent) or introduced (and elected) at the shareholders meeting. and shareholding (10 percent). In 91 percent of the sample firms. II shareholder (30 percent). About five directors per firm have been in office for more than one term. Vol. According to the Commercial Code. in 23 percent. In 1997. As discussed earlier. founders of the company acted as the chairperson (22 percent). 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. The general practice is that shareholders approve the upper limit on the total amount to be paid to all directors. a total of 562 directors were sitting on two or more corporate boards. the board had a nomination and an audit committee. and fixed fees plus performance-related pay. In one case. including stock options.
compensation is by fixed salary in 74 percent of the firms. he or she does not enjoy much power. However. In the survey. 86 percent of the firms answered positively when asked whether the largest shareholder was CEO. CEO simply follows the orders of the chairperson. and in another 21 percent CEO bought shares in the market. In such cases. These results show that the incentive compensation scheme for professional CEOs is not well developed in Korean firms. In a handful of sample firms. In the 25 firms where CEO was not the chairperson of the board. he or she was selected on the basis of professional expertise in 15 firms. CEO is also the founder in 52 percent of the firms. shareholding in three firms. the payment is about five times the CEO’s annual salary. it was proposed by CEO and approved by the board. CEO decides on important matters after consulting the chairperson in the majority (55 percent) of the firms. and was appointed by the Government in five firms. CEO generally has the ultimate power to decide on corporate affairs. in which there is no controlling shareholder.2 years. In 4 percent of the cases. In cases where CEO is not the largest shareholder and chairperson. In 20 percent. In less than 20 percent of the firms. CEOs have been in their positions for an average of 9. CEOs generally maintain their positions for a long time because they are frequently the founders or largest shareholders of their firms. The remuneration package was proposed by the board (and approved by the annual general meeting) in 56 percent of the firms. decides on important matters on his/her own in 13 out of the 44 firms. CEO is entitled to a large sum in cases his/ her contract is terminated before its expiration. 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. The firms in the survey consider steady growth of a company and maximization of the shareholder value as the most important responsibilities of CEO. fixed salary plus net profit-related bonus in 9 percent. who is not the chairperson. the survey tells a slightly different story than is generally believed in Korea. It indicates that CEO. When CEO is not the chairperson. According to the survey. .Chapter 2: Korea 99 Management CEO In the survey sample. and fixed salary plus performance-related pay including stock options in 13 percent. In 21 percent of cases. Ensuring that a company serves the public interest is considered a less important responsibility of CEO. CEO was given shares by the family.
Senior managers were even often called directors although they were not official members of the board. The bonus is supposed to be linked to company performance. This action was in response to calls by international investors and. 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. 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. Penalties for fraudulent financial reports were increased. However. and accounting standards. from IMF and the World Bank. Usually CEO suggests the maximum amount of all the directors’ compensation at the shareholders meeting to get approval and then sets the base salary and bonus for individual executives. Vol. disclosure. 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. About 40 percent of the listed companies had amended their charters to introduce incentive stock options by the 1999 shareholders meetings. Korean firms have rarely used shares for executive compensation. in particular. II Senior Executives In the past.100 Corporate Governance and Finance in East Asia. 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. One area has been to enhance the reliability of financial statements of corporations in line with internationally accepted standards. and . executives sometimes have the opportunity to buy company shares at favorable prices because the board of directors (CEO. (ii) establishment of accounting standards for financial institutions. in practice) allocates the unsubscribed portion of new shares issued in rights offerings to executives. but in practice is fixed and understood as part of a fixed salary. it was common for all senior executives to be elected as directors at the shareholders meeting. but as of March 1999 only 27 firms actually had given stock options to their executives or employees.
Consolidated reporting was introduced before the outbreak of the crisis.Chapter 2: Korea 101 (iii) establishment of accounting standards for “combined” financial statements of chaebols. Under the Commercial Code. The revised accounting standards apply to the firms subject to external auditing for the fiscal year starting on or after January 1999. The new rules also require financial institutions to recognize realized losses and allowances for potential losses arising from guarantees in the current year’s financial statements. In the ADB survey. they also have the power and duty to monitor the activities of executive directors. financial institutions must report their securities holdings at market value and recognize 100 percent of unrealized holding gains or losses in the current year’s income statement. The new accounting standards for financial institutions adopt the mark-to-market basis to account for securities. 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. 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 auditor is considered to be a subordinate of the . Korean listed companies with subsidiaries are required to compile consolidated balance sheets. Internal and External Auditing The Commercial Code requires a corporation to have at least one internal auditor elected at the general shareholders meeting. however. Only 10 percent of the respondents have followed all international accounting standards. In practice. The primary sources of reference in the revision were International Accounting Standards and US Accounting Standards. The internal auditors are supposed to play the role of the audit committee found in the board of directors in US corporations without being members of the board. 41 percent of the companies believed that they have followed some international accounting standards. Those that never adopted international standards show their willingness to do so once the Government introduces international standards. 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. but 49 percent confessed that they have not followed international standards at all. Most of the companies following all or some of the international standards in the past adopted such standards before the crisis started. Thus.
does not have the power to hire and fire the managers. outside directors. The internal auditor in the Korean corporate system can be argued to be inferior to the Anglo-American audit committee and the German supervisory board. however. Previously. The Commercial Code will be revised to allow corporations to choose from the two options: the internal auditor or the board audit committee system. About 100 listed firms will be subject to this requirement. The general organizational/social culture in Korea abhors conflict and may also have hindered effective functioning of internal auditors. there were many cases where external auditors failed to detect omissions and false numbers in financial statements of listed firms. but since 1998 a committee consisting of internal auditors. But this problem can be mitigated if auditors function under the umbrella of the board. Listed and registered corporations must publish financial statements audited by external accounting firms. If the status of internal auditors is elevated to that of independent board members. External auditors are selected for a term of three years. as a monitor of management in the Korean (and also the Japanese) system. Accepting these arguments. Big Korean accounting firms are affiliated with US accounting firms. the board of directors had the power to appoint an external auditing firm. underdeveloped market discipline for accounting firms. . the relevant laws and regulations were changed after the Asian crisis to require at least one of the internal auditors to be full time and to recommend that listed firms have outside (independent) auditors. the 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 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. 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. Vol. and lack of strong professional ethics in the accounting profession. In order to increase independence.6 years. this problem will largely disappear. In the past. The current external auditors have been associated with the surveyed companies for an average of 4. almost all firms affirmed that the external auditor is independent from the company. If the company changes its external auditor for reasons that are not listed in the relevant regulation. and creditors selects it. then the Securities and Futures Commission can appoint a new one. In the ADB survey. The problem of misconduct on the part of the external auditor was caused partly by weak penalties on wrongdoing. II controlling shareholder/CEO. This is because the auditor.102 Corporate Governance and Finance in East Asia.
This shows that a relatively larger number of shareholders send in their proxies.” Companies can increase the number . small shareholders do not attend the annual meeting and that.Chapter 2: Korea 103 2. The Depository represented 20 percent of the shares attending the meetings. A total of 326 shareholders per firm. About one fifth of the listed firms issued nonvoting preferred shares. Approval of mergers and major divestitures.” The survey shows that the Korea Securities Depository holds 69. Citizens’ coalitions sometimes solicit proxies in order to file lawsuits against a management. respectively. No companies have so far introduced voting by mail. amendments of the articles of incorporation require a “special resolution. Thus.77 percent of the shares.3 Shareholder Rights Voting Rights and Practices Under the Commercial Code. the Depository is subject to “shadow voting. One common share should have one vote. in general.79 percent of the shareholders. These voters represented only 5. Preferred shares can be nonvoting and issued up to one quarter of the total number of shares. for some firms. 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.” meaning that it should divide its votes in accordance with the accept/reject ratio of votes cast by other shareholders attending the shareholders meeting.21 percent of total shares issued. and dismissal of directors and internal auditors require a “special resolution. The above results indicate that. corporations cannot issue common shares without voting rights.3.53 percent of the total shareholdings. 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. the only purpose of allowing the Depository to vote was to help listed companies to meet the quorum requirement for the general shareholders meeting. or 10. However. Internet. representing 62. attended the last annual general meeting. A “special resolution” requires two thirds of the votes attending and one third of total votes outstanding. Under the Commercial Code. The securities companies and banks are the second and third. the Depository is instrumental in getting resolutions passed. About 100 shareholders per firm voted by proxy at the last annual general meetings (of the 40 firms answering the relevant questions).93 percent of the shareholders but 26. charter amendments. However. or telephone. The management is the most important proxy.
the Securities and Exchange Act was revised to lower the representation requirement for shareholder derivative suits from 1 to 0. was able to force a change in the charter of SK Telecom. but these can be waived by an amendment of the articles of incorporation. from 3 to 1. mergers and acquisition plans. and major investment projects (only five firms answered this question). For recommendations for dismissal of directors and internal auditors. dividend proposals. This citizens’ coalition actively contacted the management of selected companies and negotiated measures to protect shareholders.0 percent. II of votes required for a resolution to amend the articles. It also attended the shareholders meeting of several companies to present the views of outside shareholders. an activist citizens’ coalition has brought shareholder derivative suits against several large listed firms. Shareholder Protection Before the economic crisis. Changes in the authorized capital require an amendment of the articles of incorporation. Proposals put forward by management are rarely rejected at the general meetings. or block charter amendments considered harmful to minority shareholders. The company also agreed to the right of the fund . the Tiger Fund. Various measures have since been taken to improve investor protection. Only two out of 62 respondents to this question have had cases in which proposals were rejected. Vol. Those that are most likely to be rejected relate to election of directors. an institutional investor based in the US.104 Corporate Governance and Finance in East Asia. the requirement was lowered from 1 to 0. laws and regulations were generally very loose in protecting the rights of minority shareholders. Due to the changes in rules for investor protection. and for access to unpublished accounting books and records.5 percent. In four out of 62 respondents. The charges included self-dealing by a controlling shareholder and unfair subsidization of affiliated companies by a chaebol firm. the annual general meeting passed a resolution that was not proposed by the management nor the board of directors but rather by shareholders. The amendment included a provision requiring the company management to get prior approval of shareholders to undertake major investments and raise capital in international markets. Shareholders have preemptive rights. demand changes in business policy.01 percent. As an example. In February 1998 and again in March. This coalition also attempted to cooperate with domestic and foreign institutional investors to find their way into general shareholders meetings. the board of directors decides on issues of shares within the limit of the authorized capital. However.
underwriting securities firms acted also as trustees. The Commercial Code has a new clause that regards the controlling shareholder as a de facto director if he or she uses personal influence to affect business decisions of the management. The covenants in loan agreements and bond indentures were very loose. and not strictly enforced. In fact. This has strengthened the accountability of controlling shareholders as de facto CEOs. Before the amendment. managers were considered to be subject to the duty of care.Chapter 2: Korea 105 to recommend two directors to the corporate board.3. However. there was the usual conflict of interest problem and the trustee did not have the incentive to strictly enforce the covenants. it now appears that it has backed away from its earlier efforts to introduce legislation on class action suits. loans to directors. This was one of the most significant developments with respect to shareholder activism in the Korean capital market. simple. For further protection of investors. 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. bond indentures are only a few pages long compared to a few dozen pages found in advanced bond markets. Banks themselves were poorly governed and bank managements had little incentive to monitor borrowers. Thus. These have to be disclosed under the Securities and Exchange Act or approved by shareholders under the Commercial Code and other laws. but it was not entirely clear whether they had the duty of loyalty as well. mergers and acquisitions. The laws and regulations of the country protect shareholders from interested transactions. creditors did not interfere with the management of a debtor. In 1974. the Government had for some time pushed for the enactment of class action suits on false statements and omissions in disclosure materials. After the economic crisis. As for bond issues. affiliated lending or guarantees. and transactions with major shareholders.4 Control by Creditors Role of Creditors in Corporate Monitoring Traditionally. . Banks have played some limited role in monitoring the investment activities of chaebols. controlling shareholders have become more susceptible to liability claims by other (minority) shareholders. 2. The Code has also been amended to state more clearly the fiduciary duty (of care and loyalty) of the management.
However. II acquisitions. there have been concerns that the Government might use the system to intervene in the management of the business groups. 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 turn. ADB Survey Results on Borrowing and Lending Practices The ADB survey shows that a typical nonfinancial company is associated with various types of creditors. creditors now have a bigger say in court proceedings for receivership and composition. as discussed earlier. Some proponents argue that creditors should have the right to send their representatives to boards of directors of borrowers. However. Purchase of real estate should be financed by equity capital and not by borrowed funds. on average. this proposal has only a slim chance of being accepted by the Government or legislature. In 1996. Under the system. 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. Emphasis on the monitoring role of banks has been growing since the beginning of the Asian crisis. recently banks have been increasingly interested and successful in electing former bank officers as outside directors of firms that underwent workout processes. In 1994 the approval requirement was abolished. The objective of the system is to improve the financial condition of the largest business groups and promote the soundness of bank management. including. and purchases of real estate. Vol.106 Corporate Governance and Finance in East Asia. 10 nonbank . a main bank is charged with collecting and analyzing financial information of the firm and delivering its opinion on various applications and matters requiring consultation among lenders to the firm. The main bank should also monitor and restrict extension of loans to the controlling shareholder and other firms in the group. On the other hand. The firms subject to the system are required to get the approval of the main bank prior to purchasing real estate. The 10 largest business groups are required to select no more than three core companies in consultation with their respective main banks. 11 banks. Besides the setting up of an “External Auditors Committee” by firms.
More than half of the firms think that creditors have no influence on their management and decision making. and other financial institutions. or through their shareholdings. The borrower’s relationship with most banks has lasted for more than five years. in order of importance: affiliated companies. most frequently in the form of loan guarantees and less frequently by arrangement of guarantees by a third party. For more than half of such firms. About half of the respondents received assistance from other sources in the form of loan guarantees and/or provision of collateral. collateral was taken away. Most of the financial institutions are not affiliates of the borrowing company. renegotiation took place after the crisis. One tenth of the firms received assistance from the Government in loan applications. Breakdown of loan guarantors is as follows: about 40 percent of loans are without any guarantees. A few creditors exercise influence through covenants relating to major decisions by the company. For a small number of firms. and purchase or supply of raw materials. penalty was involved in rescheduling. and 17 nonfinancial corporations. banks are most likely to require collateral. whereas seven of the 17 nonfinancial corporations are. Relationships with affiliated companies providing guarantees or collateral include ownership of each other’s shares. holding shares of another company by both the borrower and the guarantor. Creditors usually exercise their influence through covenants relating to the use of loans. or creditors filed for receivership. The typical company has also maintained its relationship with five of the 10 NBFIs for more than five years. The assistance came from. Most firms feel that requirements for collateral have been tightened since the crisis started. holding companies. subsidiaries.Chapter 2: Korea 107 financial institutions (NBFIs). When loans could not be repaid on time. collateral is more likely to be required of loans for working capital than for fixed investments. mutual guarantee agreements. Among the creditors. while a third think that creditors have weak influence. payments were usually rescheduled through negotiation without any penalty. NBFIs infrequently ask for collateral. Most of the 43 firms with renegotiation experience were able to borrow from the same creditors afterwards. With respect to the types of loans. Only a few feel that creditors have very strong influence. About 60 percent of the firms have experienced renegotiation of loan repayment with creditors during the last five years. controlling shareholders. 35 percent are guaranteed by the company itself (by collateral and purchase of guarantee insurance). 16 percent .
Vol. II by other affiliated companies. 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. First. The leading creditor banks will continuously monitor the progress in implementing the signed Plans. the Corporate Restructuring Coordination Committee (CRCC) will provide arbitration. will get involved in the restructuring and workout processes. and in continued monitoring of debtors. Second. This agreement will provide guiding principles in coordinating diverse interests among creditor institutions and promoting cooperation.108 Corporate Governance and Finance in East Asia.5 The Market for Corporate Control Government Policy Toward Hostile Takeovers Until 1994. Third. Under a contract signed between the creditors and the debtor. especially banks. the delegation has the right to approve wide-ranging financial activities of the firm. In cases where the creditors are unable to reach an agreement on a workout plan. a Lead Creditor Council Agreement was signed for restructuring the top five chaebols. 2 percent by holding companies. the lead creditor banks formally signed Capital Structure Improvement Plans with chaebols. the creditor banks will send a delegation composed of bank officers to the workout firm to oversee its management. have been the driving forces for restructuring activities of the largest 64 chaebols. 2.3. This committee was set up in accordance with the provisions of the CRA. including commercial and merchant banks. Behind these new strengthened roles of creditors is the newly set-up FSC. the Korean Government maintained a policy of protecting the incumbent management of listed companies. 4 percent by subsidiaries. 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. major creditors. 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 . and 1 percent by the Government. are summarized below. banks and other institutional lenders are playing more important roles than ever before. Separate from but emulating the CRA. In this connection. The new ways through which creditors.
it can be safely stated that Korea now has one of the most accommodating capital markets with respect to hostile takeovers in the region. . As far as institutional arrangements are concerned. turning to white knights. corporations cannot limit the voting rights of large shareholders to a given maximum. Privately placed CBs cannot be converted into shares in one year. Stock purchases by tender offer were also exempted. and announcing competitive tender offers by the controlling shareholder. 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). Unlike the UK. Publicly issued CBs require three months before their owners can convert them to shares. In one case. The incumbent controlling shareholders used various tactics such as issuing privately placed CBs. Between 1994 and 1997. The shareholders already owning more than 10 percent at the time the company went public were exceptions to the rule. Unlike Germany. 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. However. Poison pills cannot be used mainly because companies cannot distribute stock options as dividends to shareholders. The reasons for failure are diverse. a total of 13 hostile takeover attempts occurred. Korea does not have the mandatory takeover rules applying to those who amass more than 30 percent of the shares outstanding (until 1998.Chapter 2: Korea 109 unless he or she obtains prior approval of the Securities and Exchange Commission. In the early 1990s the Government shifted its policy toward freer activities in the market for corporate control. Limits on acquisitions of shares of a Korean firm by a single investor were gradually increased over a six-year period beginning in 1992. more than half of these attempts failed. For takeover defense. 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. Takeover Activity As soon as the Act was amended. Companies have also utilized share repurchases. but were completely eliminated in 1998. A company cannot issue new shares to a third party without first amending the corporate charter. 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. listed firms rely mainly on shareholdings by the largest shareholder. hostile takeovers by tender offers began to appear in the capital market.
a steel company. the Government became the largest shareholder of several commercial banks through equity participation purporting to recapitalize them out of financial distress. Golden parachutes are almost unknown in Korea because the total amount of director compensation has to be voted on at the general shareholders meeting each year. In their charters. an electric power company. except for the banks. in which the Government still holds the largest ownership. Vol. was newly listed.110 Corporate Governance and Finance in East Asia. For the others. Currently the limit is 3 percent. It is harder now to find such firms. The Government-owned listed companies. As of the end of 1997. Another reason is that many listed firms belong to chaebols. which are allowed by the Securities and Exchange Act to set the limit on the ownership of shares by one single shareholder. some firms have included a supermajority provision for the dismissal of directors and provided for a staggered board. 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. For the steel company.6 Control by the Government State-Owned Enterprises Government ownership of listed companies is very limited. 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. In 1999.3. are designated as public companies. Korea Telecom. and a bank had government ownership. 172 firms (or 22 percent of listed firms) belong to the 30 largest chaebols. the limit will be eliminated when it is fully privatized in two years. Many of the takeover targets in the past did not have a controlling shareholder (group). . One reason is that the percentage of inside shareholdings (by the controlling shareholder group and the firms under its control) for an average listed firm is very high (26. 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. As of February 1999.7 percent on average as of the end of 1997 for nonfinancial listed firms). In 1998. 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. 2. Some had two or more large shareholders who had joint control of the firm but could not cooperate.
The Government has frequently imposed restrictions on the use of capital markets by large companies.3. The objective of the system was to improve the financial condition of the chaebols and to promote the soundness of bank management.1). nominated by the minister in charge of the company in question. more state-owned corporations became subject to this new board structure. In addition. the Government. administering through a self-regulatory committee of the securities industry. which was introduced in 1996. This was aimed at limiting the supply of bonds thereby stabilizing interest rates. For example. Even where employees hold . is being applied to the 51 largest business groups to which the banks extended more than W250 billion in loans and payment guarantees. especially those belonging to chaebols. Further. the main bank system. There is no active debate or discussion going on about this potentially difficult issue. But this rule.Chapter 2: Korea 111 The Government used to appoint a few public officials to the boards of state-owned corporations. was amended in 1997 to introduce a board structure consisting of a majority of nonexecutive directors.7 Employee Participation in Corporate Governance Employee participation in corporate governance is very limited. as applied to four large corporations. controlled the total amount of corporate bonds issued per month and allocated amounts to individual corporations. and approved by the Chairperson of the Planning and Budget Commission. 2. The Government’s right to send public officials to the boards was eliminated. Meanwhile. The nonexecutive directors are now recommended by a committee. 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. went into effect in 1998 to prevent them from absorbing too much of the funds available in the market. Beginning in 1999. which limits the total amount of bonds issued by the five largest chaebols.3. It was abolished before the economic crisis but another regulation. only qualified firms could issue new shares. Labor is not represented in corporate boards. 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. There were also limits on the amount raised and the number of issues per year.
Local unions in the same industry have established industrial labor federations. union members account for 54 percent of the employees. and 66 percent manual workers. The typical collective bargaining agreement has a one-year duration. About half of these firms considered the influence of the union on the management of the company to be weak. there are two federations of labor unions. In actuality.1 in 1997. This practice may be due to the fact that employees are typically submissive to their employers and that their total shareholdings are minimal. 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. Two thirds of the respondents had an organized union. Collective bargaining is. operation.9 in 1980. and 2. The respondents of the ADB survey had 2. employees of listed firms issuing shares through rights offerings are entitled to 10 percent of the rights. The union had no influence on the management in 17 percent of the firms. and development of the company.112 Corporate Governance and Finance in East Asia. Employees of companies have had the opportunity to buy shares of their employing businesses at favorable prices. Trade unions are organized on an enterprise basis.5 in 1990. employers are required to meet with representatives of labor unions at least once every three months. The relevant regulation was amended recently in order to facilitate voting by individual employees. these firms have to offer 20 percent of the shares being issued to their employees at the public offer prices. which were generally much lower than estimated values. II shares of their companies through employee stock ownership plans.654 employees per firm on average. At the national level. The percentage of shares held by the employee stock ownership plans in listed companies was 1. Under another law enacted in 1972 to induce private companies to go public. Employee stock ownership plans became popular in 1974 when the Government allowed tax and financial benefits for stock purchases by employees. . Vol. in principle. the council meetings have been superficial. 32 percent technicians and professional staff. they delegate their voting rights to plans’ representatives. of which 2 percent were senior managers. but 27 percent of them felt that it was strong. In 70 percent of the firms with organized unions. This law is not intended for wage negotiations but for employers to seek cooperation and productivity increases from workers. carried out at the enterprise level. Under the Capital Market Development Act of 1968. Under the Labor Management Council Law. In 1987. the management usually consults the union on major issues relating to the management. 2. In these firms.
Chapter 2: Korea 113
Corporate Financing7 Overview of the Financial System
The foundation of the modern financial system in Korea was laid during the early 1950s. Specialized banks were established during the 1960s to facilitate capital mobilization and strengthen financial support for underdeveloped or strategically important sectors. Most NBFIs were introduced during the 1970s to diversify financing sources, promote the development of the money market, and attract funds into the organized market. From the early 1980s, several commercial banks and NBFIs were added as part of a series of broad measures to spur financial liberalization and internationalization. These measures coincided with a shift from a government-oriented economic policy toward a market-oriented stance. Recently, the Korean financial system has been undergoing substantial changes through a comprehensive financial reform program. This program was agreed upon by the Korean Government and IMF upon the signing of a financial aid package. At present, financial institutions in Korea may be divided into three categories by function: the central bank (the Bank of Korea); banking institutions, including commercial and specialized banks; and NBFIs, including development, savings, investment, insurance, and other institutions. Corporations raise funds through direct loans from the banks and NBFIs, and by transactions with the public through the money market, stock market, and bond market. Banks To a certain extent commercial banks have engaged in long-term financing in addition to their short-term banking operations. They still tend to depend heavily on borrowings from the Bank of Korea to cover persistent shortages in their own loanable funds, although the ratio of these borrowings to their total sources of funds has decreased. Commercial banks in Korea may, as in most countries, engage in a wide range of business. In addition to their core activities, they also handle such businesses as guarantees and acceptances, own-account securities investment, and receipt and disbursement of Treasury funds as agencies of the Bank of Korea. Specific authorization is required for each area of nonbank business they engage in: such as trust ac7
The authors gratefully acknowledge the help of Prof. Bong-Han Yoon who contributed several sections of this part.
114 Corporate Governance and Finance in East Asia, Vol. II
counts, credit card business, and some aspects of securities business. Specialized banks, which function as deposit money banks alongside commercial banks, conduct a similar range of business in addition to their own areas. From the early 1980s, banking institutions moved into a number of new business areas and developed a variety of innovative products to raise their competitiveness against NBFIs, and to meet the growing and diversified demand for financial products. Examples are credit cards, sale of commercial bills discounted by themselves, factoring business, trust business, certificates of deposit (CDs) business, and sale of cover bills. They also entered such security businesses as sales of government, public, and corporate bonds under repurchase agreements; the acceptance, discount, and sale of trade bills; and lead underwriting and over-the-counter sales of government and public bonds. In the early 1980s, the trust business, which had been limited to Bank of Seoul and Trust Company, was opened to all banks. Nonbank Financial Institutions NBFIs can be broadly classified into the following categories: (i) development institutions comprising the Korea Development Bank and the ExportImport Bank of Korea; (ii) savings institutions including the trust accounts of banking institutions, mutual savings and finance companies, credit unions, mutual credit facilities, and postal savings; (iii) investment companies comprising investment trust companies and merchant banking institutions; and (iv) contractual institutions such as insurance companies and pension funds. In addition, there are various nonbank institutions that handle specialized lending such as leasing, factoring, credit cards, consumer loans, housing loans, and venture financing without receiving deposits. NBFIs have increased their share of total funds supplied since the 1980s as they have been permitted greater freedom in management and operations. The market share of banking institutions in terms of Korean won deposits dropped sharply from about 71 percent in 1980 to 30 percent in 1997; while that of NBFIs increased from 29 percent to 70 percent during the corresponding period. Differences in regulatory treatment accounted for the greater freedom in management for the NBFIs. They were allowed relatively greater flexibility in their management of assets and liabilities and, most important, were permitted to apply higher interest rates on their deposits and loans. Evenness in regulatory treatment concerning such interest rates has, however, largely been achieved following the completion of a four-stage plan for deregulation of interest rates from 1991 to 1997.
Chapter 2: Korea 115
Money Market The money market is composed of the call market and a wide range of other short-term financial markets including those for Treasury Bills, Monetary Stabilization Bonds (MSBs), negotiable CDs, repurchase agreements (RPs), commercial papers (CPs), trade bills, and cover bills. The beginning of the organized money market in Korea dates from when MSBs and Treasury bills were first issued in 1961 and 1967, respectively. However, the money market remained underdeveloped until the early 1970s when the Government took a series of measures designed to channel curb market funds into financial institutions and to systematically organize the short-term financial market. In 1972, with the passage of the Short-Term Financing Business Act and the establishment of investment and finance companies, the sale of papers issued by nonfinancial business firms and investment and finance companies was initiated. This was a first step toward the formation of an advanced money market. In 1974, negotiable CDs (large-value time deposits at banks) were introduced. In addition, call transactions, which had previously taken place between individual banks, were put on a systematic basis. In 1977, the Korea Securities Finance Corporation initiated repurchase agreements with securities companies involving bonds on a shortterm basis. Various new financial instruments, including CPs, were introduced in the early 1980s. Since 1985, there has been a sharp increase in the outstanding balance of money market instruments. This is chiefly due to product innovation and expansion in the number of financial institutions handling such instruments. The volume of money market transactions expanded from W7,995 billion in 1985 to W44,201 billion in 1990, and W98,100 billion in 1995 (as of the end of June). Stock Market Activity in the primary (new issues) stock market was extremely brisk during the period 1986 through 1989. The value of shares sold in IPOs and in rights offerings by listed companies grew 48 times from W294 billion in 1985 to W14,176 billion in 1989. But the stock market sagged in 1990, resulting in a decline in IPOs and seasoned issues. The composite stock price index declined substantially during 1990-1992 due to continued labormanagement disputes and a slowdown in economic growth. Though the market recovered temporarily from 1993 to 1995, it again went into a slump
116 Corporate Governance and Finance in East Asia, Vol. II
after 1996 until the index hit 350 in December 1997 with the onset of the financial crisis. A new stock market was organized in April 1987 to provide a new means of trading stocks for small- and medium-sized companies and venture businesses not eligible for listing on the Korea Stock Exchange. A corporation satisfying less stringent criteria can register with the Korean Securities Dealers Association under the sponsorship of at least two securities companies. This market, named KOSDAQ, is not exactly an over-thecounter (OTC) market in that, unlike the National Association of Securities Dealers Automated Quotations (NASDAQ) in the US, there are no active dealers for registered shares. Still, investors are assured of a certain degree of liquidity of the shares registered at the KOSDAQ. Though the KOSDAQ is still in its infancy, it has been showing a great potential for growth by providing liquidity to shares of small and large firms before they are eventually listed on the Korea Stock Exchange. Despite the considerable growth and good performance of the Korean stock market, many problems were exposed with the onset of the financial crisis in 1997. The major problems may be identified in the following areas: (i) corporate disclosure system; (ii) reliability of accounting information; (iii) protection of small shareholders; and (iv) inactive takeover markets. Bond Market Public and corporate bonds are issued in the Korean bond market. Public bonds include government and other bonds that are issued by provincial and municipal governments, government-owned enterprises, and government-owned financial institutions. All public bonds are implicitly or explicitly guaranteed by the central Government. Corporate bonds are those issued by private companies under the Commercial Code. The value of listed public bonds became larger than listed corporate bonds in 1986 and remains to be so. The secondary bond market consists of the exchange and the OTC market. However, as in most other countries, the OTC market has dominated trading in bonds. Almost all of the bond transactions still take place on the OTC market despite government efforts to develop a separate exchange market for bonds. Most corporate bonds were issued as guaranteed bonds where the payment of principal and interest is guaranteed by financial institutions. Nonguaranteed bonds or debentures accounted for only 15 percent of the
Chapter 2: Korea 117
total issued in 1997, although their proportion reached 30 percent in 1995. This implies that most bonds were issued according to similar conditions regardless of the financial standing of the issuing company and that the bond rating system has not been well developed in Korea. However, all of this is changing. Bond rating agencies are now applying tighter criteria. Banks have strengthened their credit reviews in extending debt payment guarantees because of tighter regulatory and market pressures on their own financial conditions. Most securities companies have all but stopped extending guarantees. One of the dramatic changes in the bond market after the IMF bailout is that most corporate bonds are now issued on a nonguaranteed basis. The proportion of nonguaranteed bonds accounted for 69 percent of the total offerings of corporate bonds in 1998. This is in contrast with the prebailout period, when the proportion of guaranteed bonds was more than 80 percent of the total offerings. One problem for the corporate bond market is that most bonds are issued with maturities of less than four years. The maturity of corporate bonds should be lengthened to generate stable longterm funds for corporations. Financial Deregulation Discriminatory government regulations in the financial sector were prevalent during the 1970s. Entry into financial industries such as commercial banking, investment banking, securities brokerage, merchant banking, and insurance was strictly controlled. Ownership of commercial banks and their internal governance structures were controlled for many decades. These factors resulted in a serious structural imbalance in the financial industry. It diminished the role and profitability of banks while encouraging growth of NBFIs. In addition, the capital structure of business firms worsened and the unorganized money market rapidly expanded. In order to reduce government intervention and to restore the balanced development of the financial market, interest rate deregulation was initiated in June 1981. A significant advance occurred in December 1988, when most of the lending rates of banks and NBFIs were liberalized. Only interest rates on long-term deposits were regulated to avoid excessive competition among financial institutions. Interest rates on remaining deposits were gradually deregulated. However, in 1989, when interest rates rose rapidly and macroeconomic conditions deteriorated, the Government again placed extensive control over interest rate movements, including window guidance. In August 1991, the Government announced the Four-Stage
2. the following measures can be constructed: Self-financing ratio (SFR) is the ratio of change in internal funds to change in total assets. short-term finance companies. the required reserve ratio was substantially lowered from an average of 23 percent in 1979 to 3. entry barriers to banks and NBFIs were lowered in an attempt to promote competition. Meanwhile. Some policy loans were also abolished. the Government announced a plan in 1981 that substantially improved foreign investors’ access to the domestic capital market.4.2. development of the money market. and the 30 largest chaebols. Korean firms have been allowed to issue CBs in international financial markets. The Government began to considerably deregulate foreign exchange in 1987 due to the shift of the current account into surplus in 1986 (see 2. listed companies. implementing the first stage in November 1991. Internal funds include retained earnings. With the privatization of nationwide commercial banks. Also. the business scope of financial institutions was greatly widened from the early 1980s. The capital market. etc. It included such important issues as interest rate deregulation. The plan was launched partially to accommodate US demands for comprehensive structural deregulation and market opening of the financial sector. In June 1993. the Korean Government announced its Financial Liberalization and Market Opening Plan. flow of funds analysis was used to examine patterns of financing of the aggregate corporate sector.1). and organization of commercial banks. especially the domestic bond market. finance companies. as a first step toward liberalization of capital account transactions. depreciation. Moreover. budget. the Government simplified various directives and instructions regulating personnel management. The Government adopted a cautious approach. . The Government handed over its controlling stakes in four commercial banks to private hands in 1981-1983. opting to bring in the plan step-by-step to avoid market dislocation from a sudden shift in the system. revision of the credit control system.5 percent in November 1981. Vol. was liberalized drastically in 1998 after the financial crisis. Since 1985.2 Patterns of Corporate Financing Corporate Financing Practices In this section. and liberalization of foreign and capital transactions. II Interest Rate Deregulation Plan. which resulted in the establishment of a number of new banks. mutual savings. In addition. On the basis of flows of funds.118 Corporate Governance and Finance in East Asia.
Securities finance became a more important source from 1988 onwards. It measures the degree of financing growth in total assets by additional debts.4 percent in the precrisis period 1988-1997. depreciation. was 71 percent during the period. and allowances) and new equity capital.Chapter 2: Korea 119 and net capital transfers from the Government. capital surplus. Table 2. but it remained less than 10 percent of total financing. Before 1988. The share of external financing. particularly in the 1990s in response to the liberalization of the capital market. In securities finance. the proportion of borrowings from NBFIs fell to its lowest value at 4 percent. on average. The corporate sector used . Incremental debt financing ratio (IDFR) is the ratio of change in total borrowings to change in total assets. including all sources other than retained earnings. the proportion of foreign borrowings in total finance rose steadily. financing by corporate bonds and CPs was more significant than by new equity. Equity capital represents the shareholders’ commitment to the business. and 1997. comprising internally generated capital (retained earnings. except for the stock market boom of 19871988. except in 1991. New equity financing ratio (NEFR) is the ratio of change in equity (stocks issued + equity other than stocks) to change in total assets. 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. the corporate sector’s most important source of external finance was bank borrowings. Meanwhile. and government transfers. 1994. It measures the degree of financing growth in total assets by additional equity. particularly in the short term. but do not include capital surplus (asset revaluation allowance and the excess of current value over issue value of stock). The SFR averaged 28. This means that internal funds after dividend payment were insufficient to finance growth in total assets.26 shows the four measures of corporate financing calculated from Table 2. depreciation. Incremental equity financing ratio (IEFR) is the ratio of change in stockholders’ equity to change in total assets or 1-IDFR. Additional equity capital used to finance growth reduces the financial cost and the financial risk of investment. This high proportion deprived Korean businesses of flexibility during recession periods due to high financial costs.25. In 1988 when the stock market boomed.25 shows the flow of funds of the nonfinancial corporate sector in Korea during 1988-1997. Financing Patterns of the Aggregate Corporate Sector Table 2.
7 12. Bank of Korea. Bank of Korea.4 0.6 8.3 6.4 10.1 12.4 21.7 2.0 3.7 1.1 1.6 4.5 16.1 (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.8 56. and Flow of Funds.3 1.7 4.8 1.2 34.1 23.5 2.5 9.2 13.8 30. and net capital transfers from the Government.7 2.2 15.0 17.4 2.4 15.5 0.9 2.2 (0.3 1.5 0.3) 11.1 1.4 0.1) 4.Table 2.3 25.6) 5.7 32.2 26.0 1997 26.9 6.1 36.7 1.7 8.0 9.7 14.3 6.6 3.7 14.8 1.0 0.5 2.0 9.6 0.5 29.2 6.6 9.6 2.9 72.7) 11.1 0.1 0. a Includes retained earnings.9 10.8 4.4 3.0 3.6 25.8 — 26.4 11.1 2.3 — 30.1 1.9 38.3) 15.8 8.7 15.9 73.0 70.0 — — — — 8.6 10.1 — — — — 12.6 4.3 3.8 (0.5 16.7 73.2 13.7 — — — — 9.6 (0. 1988-1997 (percent) 1988 43.0 5.3 1.5 13.7 1989 1990 1991 1992 1993 1994 1995 1996 22.6 3.8 -2.4 2.5 2.3 5.0 1.5 0.2 — 28.0 (0.6 Sources of Funds Internal Financinga External Financing Bank Borrowings Banks Nonbanks Merchant Banks Insurance and Others Securities Natl.2 6.3 — — — — 8.3 72.3 2.2 — — — — 9. which is the excess of current value over issue value of stock.0 2.0 0.4 71.1) 4.1 2.4 1.8 1.1 3.9 0.7 71.2 1.7 6.1 3.1 10.2 14.6 0.1 8.4 2.1 3.9 10.6 77.2 2.6 0.8 0.4 (0.4 9. .6 0.8 27.6 14.1 — 27.1 (0.1 72.6 4.6 11.4 27.2 5.6 5.7 10.4) 13.3 10.0 3.3 3.2 0.7 10.9 9.7 8.1) 6.4 (2.8 1.1 27.3 16.0 11.0 22.1 17.6 11. Source: Understanding Flow of Fund Accounts.25 Flow of Funds of the Nonfinancial Corporate Sector. depreciation.7 7.8 17.5 2.0 16.3 27.7 2.8 1.3 30.4 — 28.7 13.6 9.0) 12.9 34.6 9.4 27. b Includes capital surplus.7 11.7 (0. 1994.7 4.0 10.2 10.9 28.4 8.3 6.6 1.8 15.4 2.4 27.7 10.4 1.
4 27.4 percent. indicating a high financial risk position. Across industry.0 57. Source: Calculations from Understanding Flow of Fund Accounts.0 27. and IEFRs were declining.2 IDFR 36. In periods of high economic growth such as in 1988. and Flow of Funds.6 62.3 60.9 22. Manufacturing financed 54.4 NEFRa 20.1 12. There were significant time trends.26 Financing Patterns of the Nonfinancial Corporate Sector.0 5. .27). While SFRs.Chapter 2: Korea 121 Table 2. respectively.4 IEFR 63.1 percent in 1988 during the stock market boom. 1994.7 26.0 42. NEFRs.6 percent and 1. IEFR ranged from 32 percent to 64 percent of asset growth during the boom years.5 31. NEFR registered 20.7 40.3 59.5 68. dropping to 26.7 40. IDFR reached 73. and the total debt ratio was much higher in 1996 and 1997 at 62. SFR peaked at 44 percent. but also continuously fell. It dropped to 28 percent the following year.3 11. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average a SFRa 43.7 40.6 percent.3 73.3 percent in 1997. in the manufacturing sector.9 60. was financed by additional debts. higher than the aggregate 40. Bank of Korea.6 26.8 percent of its total asset growth through debts. Incremental financing from equity was 40.5 percent.8 62.4 12.8 28.6 percent.7 30.9 46. Bank of Korea.2 percent of the growth in total assets.9 28.5 percent in 1997.1 39. additional equity to finance 12. declining to 26.7 percent in 1997.6 percent over the 10-year period. 45.1 17. On average. higher than the aggregate 28.3 59.0 11.2 percent of incremental asset growth was financed by equity. the corporate sector relied heavily on external financing for its expansion.7 28.4 percent.2 37. but plunged to 5. an average of 59.5 and 76. The balance.6 Excludes capital surplus.4 37. respectively.5 12. Lower income diminished the industry’s equity position toward crisis year 1997.3 27. Its IEFR and NEFR dropped to 23.8 10.1 53.3 12.9 percent by 1997 when net profit margins were negative.4 percent (Table 2. average SFR was 37.1 26.7 9.
6 54. It had the highest average SFR in 1988 at 31.5 7.4 46. storage.8 IEFR 65.5 1. and fell to about 10 percent in 1997. their average SFR was higher.4 63. then increased to 20. II The construction industry showed the most cyclical pattern in annual asset growth. the proportion of short-term borrowings in total financing has been high. one year ahead of the other industries. Since 1992.8 4.2 percent in 1993. Table 2.and medium-sized firms.4 3. gas. with the total debt ratio much higher in 1995-1997 at 82 to 84 percent.0 42.6 4.0 30.2 5. Vol.9 percent.7 47.5 NEFRa 9.3 28.1 29.2 3.0 42. from 17.0 3. and communication sector had relatively high incremental equity ratios.6 37.5 23. Financing patterns of the wholesale.7 37. large firms showed more cyclical patterns in these financing ratios than small. On the other hand.4 37.8 50. These sectors had relatively low equity financing ratios and high total debt ratios in financing asset growth between 1988 and 1997. retail. and hotels sector and realty/renting/business activities sector were similar. In 1997. Total debt financed an average 74.6 3. and steam) and the transportation.8 percent in crisis year 1997. and low total debt and short-term borrowing ratios.2 .7 37.0 57.2 62. the utilities (electricity. this dropped further to 15.6 45.4 54.27 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. Equity financed an average 25.4 47.7 47.6 53.122 Corporate Governance and Finance in East Asia.6 62.2 21. Categorized according to company size.9 6.8 percent in 1990. explaining partly the collapses of several construction companies in 1995.3 52.6 53.9 IDFR 34.5 76.1 percent of total asset growth for the period.6 36.9 percent of asset growth. which decreased to 8.7 percent in 1996.6 37. Since large firms were more profitable. the two sectors also had low equity financing ratios and high debt financing ratios.4 45.
7 80.7 53.1 19.5 21.6 71.0 .3 1996 16.8 25.2 23.2 5.3 8. Hotels 1988 33.2 18.1 4.2 1995 16.8 76.3 4.7 6.3 47.9 80.7 1997 8.6 9.2 29.8 81.0 17.8 29.8 2.9 1992 56.5 29.0 31.0 68.3 4. and Communication 1988 64.9 9.3 84.9 1.2 10.7 1994 53.7 78.9 Construction 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 31.9 1.1 25.4) 2.9 52.6 8.0 4.6 7.8 74.0 1992 24.5 23.8 70.9 2.5 62.0 60.0 1.6 2.2 25.7 15.9 30.7 15.5 20.5 70.Table 2.27 (Cont’d) Year SFRa NEFRa IDFR 53.2 20.2 70.3 21.9 33.1 66.2 4.1 59.3 10. Household Goods.2 3.3 (9.0 82.6 73.4 2.1 Trasport.5 12.9 1.2 74.7 Wholesale/Retail Trade.8 1994 15.4 IEFR 46.1 69.9 1989 63.9 29.0 34.0 74.5 1996 42.0 10.3 19.0 3.6 8.4 28.7 78.6 4.7 1989 26.2 46.0 1990 12.9 15.5 76.7 7.4 62.5 1993 22.7 41.6 14.9 47. Storage.9 16.5 1.4 26.6 9.0 1990 50.9 Average 19.1 1991 14.3 57.9 1993 63.2 8.7 42.6 37.5 87.8 1991 51.0 40.9 20.6 1997 29.1 70.4 1995 53.3 7.8 54.6 37.0 65.2 Average 53.8 4.1 84.8 9.0 0.
7 1994 8.0 21.3 29.8 17.4 (107.1 1989 34.27 (Cont’d) Year SFRa NEFRa 6.0 (0.1 34.6 52.0 33.1 71.3 3. Source: Calculated using data from Bank of Korea.1 42.4 0 0 0 0 1.3 62.4) 3.9 57.9 29.4 47.0 1997 24.9 45. The large firms had a higher proportion of external financing in 1996-1997. The trend was reversed in 1996-1997.0 0. II Table 2.3 207. however.4 1994 72.and mediumscale firms.7 1996 18.8 1993 11.3 92.9 28. and Business 1988 51. Renting.7 18. a Excludes capital surplus.4 5.0 79. IEFR = incremental equity financing ratio.3 81. Gas.8 36.6 1991 18.6 1. Vol.6 IDFR = incremental debt financing ratio.5 8. Long.1 1993 55.5 22.9 IDFR 31.9 Average 75. .0 53.3 7.9 64.6 Real Estate.3 Electricity.2 63. and Steam Supply 1988 118.4 1.9 65.7 14.8 1990 19.5 77.4 0.8 Average 22.7 69. Financial Statement Analysis Yearbooks.1 1991 56.4 1996 45.6 1995 17.1 35.4 1995 62.7 37.0 43.4 7. NEFR = new equity financing ratio.0 0.0 1992 51.1 0.6 7. when large firms had much lower equity financing ratios and higher debt financing ratios than small.7 70. Higher growth in total assets and sales and easier access to debts by large firms could be reasons for this.8) (35.3 31.8) 7.6 1997 23.1 54.and short-term borrowings of these firms shot up in that period.8 135.3 85.2 1992 18.124 Corporate Governance and Finance in East Asia.6 1990 82.0 67.0 56.1 70.6 1989 118.0 46. Their average IEFR was also higher and IDFR smaller.4 IEFR 69.0 1. SFR = self-financing ratio.
Their shortterm borrowings accounted for 86. They had easier access to bank loans and the markets for corporate bonds and CPs than nonlisted companies. Another key feature of corporate finance in Korea is the widespread use of loan guarantees among the top 30 chaebols. In 1997.8 percent of their total finance in 1997. and were large borrowers. 153. and the top five chaebols.5 percent and their total external financing. at an average 70. Group-member firms borrowed less. External financing reached 94. for listed companies.1 percent of their equity capital. the lowest ratio of 58. compared with the entire corporate sector’s 35 percent and 65. Cross-payment guarantees have been declining since 1993 and reached 91.8 percent. All of the top 30 chaebols relied heavily on short-term borrowings. and using cross-payment guarantees among affiliated companies. Financing Patterns of Chaebols For chaebols.7 percent for all listed companies.3 and 89.6 percent. the top 11-30 chaebols had the highest guarantees commitments at 207.4 percent. the average SFR was 28. and higher than that of listed companies (Table 2. 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. compared with 89.6 percent of total asset growth.7 percent.9 percent. The average IEFR of the top 30 chaebols of 29. The debt financing ratio of listed companies was high since they relied more on external financing. the NEFR of the top 30 chaebols plunged while the debt ratio increased substantially.Chapter 2: Korea 125 Financing Patterns of the Publicly Listed Firms The average SFR of listed companies in 1994-1997 was much lower than that of the corporate sector as a whole (Table 2.2 percent. In 1996-1997. In 1997.29). . 91. The average IEFR and IDFR were 10.5 percent is lower than that of the corporate sector in general. The proportion of their short-term financing averaged 72. The chaebols’ drive to expand their empires resulted in heavy borrowings. about the same as that of the corporate sector as a whole. respectively. the IDFR of listed companies increased to 93. They were able to borrow easily from banks by issuing corporate bonds and CP.9 percent.30).28). but higher than that of listed companies. the top 6-10 chaebols.7 percent.3 percent of their equity capital in 1997 (Table 2.
2 36.7 13.5 8.2 10.29 Financing Patterns of the Top 30 Chaebols. Source: Calculated from data obtained from data files of the Korea Listed Companies Association.5 2.5 Year 1994 1995 1996 1997 Average a Excludes capital surplus.6 61.3 Year 1994 1995 1996 1997 Average a Excludes capital surplus.3 28.9 NEFRa IEFR 14.9 7. Source: Calculated using data of Seung No Choi.1 1. 1994-1997 (percent) SFRa 41.4 88. Korea Federation of Industries.6 70. Table 2.4 29.2 23. .8 76.3 86.4 1.6 IEFR 42.28 Financing Patterns of Listed Companies.6 0.Table 2.2 1.3 IDFR 57.6 1.4 12.4 38.3 5.6 11.3 1.2 NEFRa 1. Largest Business Groups in Korea.5 2. 1994-1998 (percent) SFRa IDFR 85.1 93.5 91.9 6.1 8.7 1.5 8.8 89.8 22.7 12.
Further. According to the ADB survey. This change implies that firms now give more attention to financial risks. Firms now prefer internal funds and new equity capital.7 150. the Government applied high tax rates on net profits of corporations. These are followed by loans from banks. First. in order of ranking.9 — — — 1994 258. This attitude appears to have changed after the crisis because reserves and retained earnings and rights issues became the preferred financing choices.9 — — — 1996 105. Interest payments on debts were considered a loss when calculating taxes. bond issues. bond issues.0 207. Source: Fair Trade Commission and the Federation of Korean Industries.30 Cross-Payment Guarantees of the Top 30 Chaebols.1 — — — 1995 161.3 58. Korean firms preferred debt financing (bank and nonbank borrowings). company preferences in financing investment projects before the crisis were. 1993-1997 (as percentage of equity capital) Rank Top Top Top Top 30 Chaebols 5 Chaebols 6-10 Chaebols 11-30 Chaebols 1993 469. chaebols could easily borrow funds from banks and NBFIs by using cross-payment guarantees. And fifth. the Korean economy was plagued with high inflation. Few firms ranked loans from NBFIs as their first preference. Fourth. poor financial and corporate governance resulted in overlending by banks. inefficient investment and excessive diversification of corporations. and reserves and retained earnings. Third.Chapter 2: Korea 127 Table 2.1 — = not available. . the Government provided implicit guarantees on bank lending and large businesses. loans from banks. There were several reasons for this. especially in the 1970s when real interest rates of bank loans were negative.3 200. and underdevelopment of the stock market. rights issues.9 153. Financial institutions did not strictly screen their loan projects and monitor their debtors. Second.3 64. more than half of bank loans were priority loans with low interest rates. and extended loans based on cross-payment guarantees. Controlling shareholders usually tried to avoid dilution in their shareholdings for fear of losing control. so that the firms engaged in lobbying to gain access to them. Factors Influencing Corporate Financing Choices Until recently. and loans from NBFIs.0 1997 91.
more than half (53 percent) hedged against exchange rate fluctuations. and futures and other financial derivatives. some (36 percent) thought that a hedging facility was not available or not working properly. Other factors include. in selecting financing sources. Few companies felt that hedging was too costly or was unnecessary as the exchange rate was considered fixed. firms give their first consideration to minimization of transaction and interest costs. even with a heavy debt burden.128 Corporate Governance and Finance in East Asia. About half of the respondents of the ADB survey borrowed foreign currency denominated loans from foreign banks. and Corporate Performance Corporate Performance and Financial Structure Many chaebols were vulnerable to unfavorable cyclical shocks such as the business downturn at the end of 1995 and the terms of trade shock in 1996.36 percent on average for these companies. and reduction in tax burden.4. II In seeking external financing. Diversification. 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. they survived for two to three . the majority (60 percent) of the firms responding to the ADB survey look first for nonaffiliated financial institutions. The percentage of foreign currency denominated loans hedged against exchange rate risks was 21. in order of importance. the percentage of foreign currency denominated debt in the portfolio was 14. For these firms. According to the survey. These survey results indicate that many companies were not very attentive to exchange rate risks (and possibly to financial risks in general). Among those that never hedged against exchange rate risks. Among the responding companies that had foreign currency denominated loans. Only a few firms sought foreign loans because domestic loans were not available.5 percent at the end of 1997. maintenance of the existing ownership structure.3 Financial Structure. Vol. A futures exchange launched in 1999 trades foreign exchange options. This preference has changed little after the crisis. Nonetheless. 2. ensuring the liquidity of the company. Korea now provides a better environment for financial risk management. and others (29 percent) expected the local currency to appreciate in value. many firms (or 42 percent) never considered hedging.
But since 1992. Nam et al. (iv) In terms of EBITDA to total assets.3. In order to determine the relationship between financing patterns and corporate performance.2. the trend was reversed in 1993 when the interest coverage ratios of the top five chaebols exceeded those of the independent firms. These findings indicate that independent firms have had a lower leverage and performed better financially. except in 1991.. the top five chaebols and the top 6-70 chaebols had similar ratios. (ii) In terms of net income to total assets. Table 2. However. (i) In terms of total borrowings to total assets. Among the main findings were the following. The ratios of the top 6-70 chaebols were lower than those of the top five chaebols. the ratios of nonchaebols were remarkably higher than those of the top 670 chaebols during the entire period. Interest coverage ratios of non-chaebols were higher than those of the top 6-70 chaebols during the entire period. the ratios of independent firms were higher than those of the top five and top 6-70 chaebols during the entire period. except in 19931995 when semiconductor prices were extraordinarily high. They were also higher than those of the top five chaebols until 1992. the top five chaebols’ ratios were much higher.Chapter 2: Korea 129 years before collapsing at the time of the 1997 financial crisis (2. (iii) Interest payment coverage ratios are calculated as operating earnings over interest expenses. The 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. They were also higher than those of the top five chaebols until 1991. .13). Operating earnings are earnings before interest payments and taxes plus depreciation and amortization (EBITDA). as well as lax financial supervision (Nam et al. 1999). but the ratios of independent firms were much lower. 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. (1999) compared the financial positions of 504 chaebol affiliates and non-chaebol independent firms during the period 1986-1998. Those firms whose interest payment coverage ratios are below 1 are likely to go bankrupt.
Their subsidiaries. second highest in the top 6-30. Vol. But the net profit margins of the top 31-72 chaebols were higher than those of the top five in 1985-1992. Government intervention. larger research and development expenditure. In terms of the net profit margin (the ratio of net profits to sales revenue).31).5 The Corporate Sector in the Financial Crisis This section looks at the various causes of the crisis in 1997. had easier access to credit than the top 31-72 chaebols.130 Corporate Governance and Finance in East Asia. Meanwhile. Indicators such as increasing debt-to-equity ratios. Chaebols have been subsidizing new or low-profit industries by transferring resources from high-profit industries through inside dealings. its profit rate declined. The diversification of chaebols under workout was much lower than that of the top 6-30. net profit margins of the top 31-72 chaebols were always higher than those of the top 6-30. the top five chaebols outperformed the top 6-30 chaebols for most of 1985-1997. The diversification of the top five chaebols remained at about the same level within the period. and easier access to cheap credit. and lowest in the top 3172 chaebols. however. This indicates that excessive diversification and inefficient investment of the top 30 chaebols resulted in relatively low net profit margins (Table 2. The differences in the degrees of diversification among the three groups are substantial. the top 6-30 and 31-72 chaebols gradually increased their diversification beginning 1990. debt guarantees for free. 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. rising nonperforming loans (NPLs) and falling . or outright transfer of resources due to poor corporate governance practices. except in the recession years of 1996-1997. too. the degree of diversification was highest in the top five chaebols. During 1985-1997. The degree of diversification of chaebols that fell into default. had a significant role. court receivership. then declined to levels lower than those of the top five in the years of economic downturn 1993-1997. 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. and composition was lower than that of the top 6-30 but higher than that of the top 31-72 chaebols on average. 2.
2 (0.2 (0.3 1.5 (0.4) (0.3 1.2) 2.4 (2.9) 2.1 (1.1 0.4 (0.2) (4.3) 1.1 1. and Reconciliation Kia Jinro Hanbo Sammi Newcore Haitai Chungku Kukdong Daenong Halla Workout Target Kuhpyong Kangwon-sanup Pyuksan Sinho Tongil Kohap Sinwon Anam Donga 1985 1.4 (1.8) (4.3) 0.3 1.7) (0.2 1.0 (2.1) 0.7 1.6 3.9 1.4) (1.6 0.1 1.3 3.1) 2.7 1.1) (6.1 0.6 5.2 1.8) 1.9) (8.3 (0.7) (1.3 1. p.4 1996 0.31 Net Profit Margins of Chaebols.8 0.2) 1.8 0.6 0.2 1.9 0.3 0.5 (4.8 (0. 1998.6) 0.6 0.7) 0.1) (1.0 (0.1 1.5 (0.0 1992 1994 1.3) 0.2 1995 3.3) (12.0) (3.8 0.7 0.4 0.0 4.7 1.2) (0.3 1.4) (1.4) (2.9 1.8 1.2 1.5 (0.6 1989 1.1) (2.0 0.4 1.7 0.8) 0.5 1.2 0.3) 0. .3) (1. Chung Ang University.4 1.4 (0.5 (6.3 (0.0) (0.8) (20.8) 2.9 8.9) 2.3 (0.8 (0.8 1990 0. Court Receivership.8) (1.5) 0.1 (0.1 1.8 3.6 (10.2 (0. Management Research Institute.4 1.0 0.7 (4.5 (0.2) 2.8 1.5 0.6 (0.2 (17.7 (0.3 (3.7 (1.8 0.1 1.2) (13.1 (4.8) 0.9 (0.1) 2.6) (12.6 (0.6 0.9) 2.9 1.1 0.6 1.0 6.3 1.4 1.1) 1.6 1.4 (1.5) (2.2 (1. 1985-1997 Item Top 5 Hyundai Samsung LG Daewoo SK Top 6-30 Top 31-72 Default.2 4.1 0.3 1.3 1.4 (1.8) (1.8) 0.1 0.8 0.9) 0.6) (20.7 0.7 3.3 1.3) 0.3) 12.8) (11.1 0.2 1.7 — (0.0) (0.3) (0.9 0.3) 1.5) (0.3 0.9 0.7 2.4) (1.1 1.2) 1.7 0.2 (0.1 (3.3 1.1) 1.4 2.1) 0.9 1.1 1.4) (4.3 0.5 1.5) (2.2) (0.7 0.7) 0.6 7.8 3.2) (4.0) 0.2 1.3 (0.8) 0.1) (1.11.8) 1997 0.8 (0.6 0.1 0.0) 0.1) (5.Table 2.5) (1.9) (1.1 0.5 1.1 (4.4 (0.9 0.4 0.7 (0.7 1.8) 0.5) (7.2) 0.1 (9.0 1.7) (0.9) (9.0 1.4 0.6) 0.4 0.8) (37.3) 0.8) (3.0) 0.8) (0.6) 0.0 (7.0) (4.3) 0.4) (6.2) (13.5 4.6) (12.6 0. Background and Task of Structural Adjustment.1 2. Source: Whan Whang.3) 0.6) (0.1 4.5 1.6 1.6 1.6 1.3) (0.3 1.1) — = not available.3 0. Beyond the Limit.7 0.1 0.2) 1.2) (3.5 2.6 0.2) (4.5 1.0 1987 1.3 0.6) 0.6 0.6) (0.
outside directors.132 Corporate Governance and Finance in East Asia. They were then almost automatically elected at the general shareholders meeting. II corporate profitability were signs that the Korean economy had reached the edge of a slippery slope. Thus. after the crisis. Vol.1 Weaknesses in Corporate Governance Concentration of Ownership and Entrenched Management Concentration of ownership has been the root cause of many problems related to corporate governance. Until 1997. The hold was tightened by the practice wherein candidates for directors were handpicked from among the managers by the controlling shareholder. a committee composed of internal auditors. the recently adopted Code of Best Practice in Corporate Governance recommends the strengthening of the board system. the Korea Stock Exchange introduced listing rules requiring that listed firms elect “independent outside directors” to comprise not less than a quarter of the board members. Now. and to the development of the market for corporate control. and creditors should select (recommend) the external auditor. 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. Along with government policies to protect the status quo. Thus. this has led to entrenched management. 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. A remote trigger in the Thai crisis was all that took to push the economy over the edge. The most serious problem among most Korean listed firms has been that a controlling shareholder acting as CEO could never be replaced. the independence and objectivity of the external auditor were often questioned. Meanwhile. Ownership concentration also had ramifications on corporate transparency. a firm’s board of directors had the power to appoint an external auditor. But in 1998.5. 2. Until 1997. internal auditors cannot be expected to perform their function independently of management. . Moreover. the boards of all listed companies were composed of insiders only. 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. as a whole. 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. Many changes were introduced to promote M&A in the 1990s. However. 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. Traditionally. These included restrictions of shareholdings of institutional investors. hostile takeovers in Korea will likely be rare in the future. restrictions of voting rights of shares of institutional investors. Meanwhile. corporate accounting information was not reliable due to the lack of independence of external auditors. as well as institutions. In this situation. and restrictions on hostile takeovers. the Government maintained a policy of protecting the incumbent management of a listed company. when a large diversified chaebol. There were no effective monitoring mechanisms for its management. regulatory and practical difficulty in implementing proxy voting. however. Many of the takeover targets in the past did not have a controlling shareholder. One reason is that the percentage of inside shareholdings for an average listed firm is very high. a large issuance of preferred stocks with no voting rights. Dominance of Chaebols A chaebol is tightly controlled by the largest shareholder. usually a member of the founding family. Banks did not function as monitors of corporate management although they were shareholders as well as the most influential creditors. prevalent window dressing practices. These internal dealings made strong firms weak and helped marginal firms survive.Chapter 2: Korea 133 There had been some devices to protect management so that companies could indulge in business activities without fear of takeover. Diversification can reduce chaebols’ risks through the portfolio effect. Under the direction of the controlling shareholder. has an unsound capital structure and . participated in the stock market as short-term traders rather than long-term investors. and some differences in Korea’s generally accepted accounting principles from international standards. 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. profitable firms within a chaebol tended to subsidize unprofitable firms.
2. Vol. 2. capital. the intervention later resulted in the accumulation of adverse side effects: underdeveloped product. financing choices of listed firms in order of preference were bank loans. This indicates that too much diversification and overinvestment in the top 30 chaebols resulted in relatively low net profit margins. However. Profitability of the top 6-70 chaebol firms has been lower than that of the top five chaebol firms. This effectively becomes an exit barrier for chaebols and would justify the intervention and support of the Government.5. share issues. the financial distress of one or a few marginal firms can lead to a chain of bankruptcies across the entire chaebol. although their subsidiaries had better quality workforce and easier access to cheap credit than the top 31-72 chaebol affiliates. and internal funds.3 Manifestations of Weak Corporate Governance and Government Intervention Preference of Debt Over Equity Financing in the Precrisis Period Before the crisis. The Government’s supervision and regulation of financial institutions were poor. bond issues. The Government and the Bank of Korea did not have accurate information on the extent of transactions that corporations and financial institutions had abroad. The new preference ordering is as . and other individual markets. II strong financial links among its member firms through investments and cross-guarantees. while (non-chaebol) independent firms had much lower borrowing ratios. Financing preferences changed drastically after the crisis. Such problems may eventually cause ripples through the entire economy. and a high degree of inefficiency in the economy. the authorities did not properly check on banks’ lending practices—banks did not screen the lending projects and evaluate the creditworthiness of corporations properly. Further.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. Net profit margins of the top 31-72 chaebols were higher than those of the top five or of the top 6-30.5.134 Corporate Governance and Finance in East Asia. as the latter are well established in most business areas. prevalence of rent-seeking and morally hazardous behavior by economic decision makers. As mentioned earlier. the typical chaebol firm had an extremely high DER.
The ratio of external debts to GDP reached 48 percent at the end of 1998. were advantageous to chaebols because they were in an “ideal” position to meet the loan requirement through cross-guarantees among their member firms. won/dollar nondeliverable forward rates increased rapidly. However. share issues. After the financial crisis erupted in Indonesia and Thailand. overseas borrowing became difficult and higher interest rates were charged on foreign borrowing.Chapter 2: Korea 135 follows: internal funds. and bond issues. Other factors also contributed to this preference. The preference for debt finance also led to a relatively large foreign debt. The financing choice of listed firms was also influenced by the underdevelopment of the stock market. total foreign debt amounted to $157. bank loans. Bank loans. Implicit guarantees by the Government on bank loans to large businesses. . reducing foreign exchange reserves to a dangerous level. obviously contributed to overlending and aggravated the situation. Although the ratio of stock market capitalization to GDP in Korea was not very different from those in the Philippines and Thailand. The lending practices of banks. the top 30 chaebols showed a DER of 519 percent. which is far higher than the average ratio of around 400 percent for nonfinancial listed firms. as evidenced by occasional. 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. 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. which generally required guarantees or collateral. 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 exchange rate (won/dollar) increased sharply and the financial crisis erupted in Korea. Nonpolicy loans were also considered to be cheap because of interest rate regulations. As of the end of 1997. The high proportion of foreign debt led to a mismatch problem where borrowers were unhedged against foreign exchange risk. In the international financial market.5 billion. large-scale bailouts of financially distressed firms. In November 1997. the Government and the Bank of Korea defended the currency. 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. signaling a bearish speculative move on the won. 63 percent of which was short-term. consisted of high proportions of policy loans. At the end of 1996.
These were the definitions until 30 June 1998. Financial Sector Vulnerability Because of financial losses in the corporate sector. II Inefficient Corporate Investment and Low Profitability Ownership concentration among Korean firms. Doubtful loans are those for which interest is not received for six months or longer. and there is no collateral. In 1997 they became negative. and shareholders’ equity of all industries. regardless of whether it is caused by large personal holdings of the controlling shareholder or by pyramiding.6 percent in June 1998. Vol. The Government could hardly help them because of the number and magnitude of business failures.136 Corporate Governance and Finance in East Asia. a large number of construction companies failed due to the recession in the real estate market and decline in real estate prices. the NPL ratio reached 7.1 percent in 1996. the NPL ratio of commercial banks increased rapidly from 4. The banks and merchant banks lent to large businesses. the ratios of net profits to sales. However. Meanwhile.000 in September 1998 (Table 2. Before the crisis. Following the “three months” definition. Further. It jumped to 17. has given rise to various types of self-dealings by the controlling shareholder. Fixed loans are those for which interest is not received for six months or longer. starting 1 July 1998. were low in 1996 and 1997. reaching highs of 6 percent in 1997 and 8. .000 from December 1997 to February 1998. especially chaebols. the NPL ratio8 of banks and other financial institutions began to increase. and estimated losses. they are defined as loans for which interest payments are overdue by three months or more. 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 bank supervisory 8 NPLs of banks comprise fixed (substandard) and doubtful loans. The inevitable result of inefficient investment was a fall in corporate profits. Moreover. nine out of the 30 top chaebols failed. without strictly evaluating the creditworthiness of businesses and the profitability of projects.200 in 1997.32). total assets. They utilized mutual payment guarantees among their affiliates and believed that they would never fail.7 percent in 1997.000 during January-September of 1998. and returned to about 1.000 per year starting 1992. then 20. excluding the financial sector. The monthly number reached more than 3. decelerated from March 1998. legal and other barriers prevented the exit of financially nonviable firms. and the pursuit of growth through excessive diversification and inefficient investment. The number of insolvent companies increased rapidly in 1991 and doubled to more than 11. According to the “six months” definition. and there is collateral.
Policymakers thought that economic growth would resolve the NPL problem without the need for corrective action.131 1.637 6. ROEs and ROAs of Korean and Japanese banks were low compared with those of the US. the ratio reached 7-8 percent. Meanwhile.517 2.4 Shortcomings in Macroeconomic Policy The macroeconomic framework also contributed to the crisis in 1997.259 2.850 3.859 3.502 11.135 1.759 6. This speculation was said to be one of the causes of the financial crisis in Korea.250 2.573 3.985 Services 3. and declined to 4-6 percent in 1994-1996 (Table 2. The difference between the Korean and Western definitions of NPLs left foreign investors with suspicions that the size of NPLs in Korea might be much larger than the government-announced magnitude.553 3.544 2. Source: Bank of Korea. those of domestic banks were lower in the 1990s. As a result they had largely overvalued currencies.210 1.472 2.238 4. and continuous and large current account deficits.China.856 7.Chapter 2: Korea 137 Table 2.265 6. The current account deficits in terms . low efficiency.244 3.5.673 Construction 380 354 242 195 294 585 1.589 171.855 6.107 6. In 1990-1993.992 11. and Taipei.133 3.053 5.657 3. This was mainly due to the high ratios of NPLs. 2.417 Others 152 132 108 97 88 161 326 252 274 302 553 861 952 Note: 1998 figures cover only January-September.647 8.890 4.33). 1986-1998 Year 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total 4.159 10. Compared to ROAs and ROEs of domestic branches of foreign banks.32 Number of Firms with Dishonored Checks.386 5.754 3.027 Manufacturing 1.979 8. Exchange rates were virtually pegged to the US dollar in all troubled Asian countries.769 9. and large government-directed loans.255 13.114 811 706 696 866 1. European countries. authorities were not too concerned about the high NPL ratios at Korean banks in 1997 simply because the high and rising ratios had precedents.751 1.457 2.69 20.
Thailand -8. 1990-1998 (W billion) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 a Total Loans 90. Meanwhile large businesses could not legally lay off workers.China.237 Estimated Loss (C) 958 920 840 816 213 385 490 490 648 NPL (A+B+C) 7.1 percent (1995). Source: Bank of Korea. and Indonesia -3.192 Doubtful (B)b 952 1.China.190 9.520 194.310 6.929 11. Related to this.33 Nonperforming Loans of General Banks.170 1. because of the rigid labor market.649 375.0 7. of percentage of GDP were as follows: Malaysia -8. In addition to the overvaluation of the won. II Table 2.0 8.390 12.6 percent (1995). Real interest rates in Korea had been two to three times higher than those of Japan or Taipei.0 7.556 118.600 10.8 5.6 Fixed loans are those requiring collateral and for which interest is not received for six months or longer.077 NPL Ratio (%) 8.1 6.562 18. The main result of the rigid labor market was a “high-cost and lowefficiency” economy. The pegged currency also encouraged foreign borrowing as investors believed that the exchange rate would remain stable. Mass layoffs became legally possible only after the economic crisis.954 9.475 143.430 12.138 Corporate Governance and Finance in East Asia.832 337.176 7.827 289. the terms of trade deteriorated 12 percent in 1996 and 11 percent in 1997.116 1. Korea -4.4 5. the ratio of short-term debt to foreign reserves was very high.221 8.910 1.997 9. It was estimated that the Korean won was overvalued by 20 to 30 percent from 1989 to 1997. which led to large corporate losses. judging from the real effective exchange rate indexes using unit labor cost indexes as a deflator and 1985 as a base year. the hourly wage rate in the Korean manufacturing sector was higher than in Singapore or Taipei. although per capita income in Korea was much lower. In 1997.160 11. Businesses served as a social safety net.705 160. . b Doubtful loans are collateral-free loans for which interest is not received for six months or longer.736 8.584 2.484 11.584 Fixed (A)a 5. Vol.652 29.874 22.266 10.8 percent (1996).537 10. even in times of economic slowdown.1 7. and 30 percent in 1996.6 percent (1995). Land prices and real estate rents were also high compared to trading partners.639 1.739 241.2 4.
6 2. Nonviable firms and financial institutions. Ailing banks needed to be recapitalized after the huge amount of NPLs was disposed. which were laden with huge amounts of debt and were on the verge of bankruptcy. The FSC—later called the Financial Supervisory Service (FSS)— which is in charge of prudential regulation of financial institutions. the excessive amount of debt of Korean corporations had to be reduced to a sustainable level. However.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.6. has been actively utilizing its influence to motivate institutions to coordinate debtor firms’ restructuring activities. embarked on their own restructuring programs and/or implemented restructuring demands of the creditor banks. Other firms experiencing financial distress were subjected to workout procedures through negotiations between debtors and creditor institutions. ‘Voluntary’ Restructuring Chaebols have been under pressure from the Government to abolish their informal group headquarters to increase the managerial independence of member firms. Downsizing by curtailing employment has been prevalent. Corporations. 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. and subsidizing money-losing units. 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.Chapter 2: Korea 139 2.6 percent as of the end of June 1998 to no more than 200 percent by the end of 1999. . They have been pressured to stop such practices as providing loan guarantees. the immediate objective centered on restoring the international investment community’s confidence in the Korean economy. Measures have been taken by several chaebols to streamline operations and improve incentives of managers and employees. A guideline informally promulgated by FSC required the 30 largest chaebols to lower their DER of 412. including banks. To achieve this. had been forced into bankruptcy proceedings or merged into healthier entities.
More than 59 percent of potential buyers were foreign firms. 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. Noticing this disincentive. Korean firms have been slowly stepping up their restructuring since the latter half of 1998 as the economy began to show signs of recovery. This number was at 779 firms in April and grew to 1. On the other hand. The data also show that about 24 percent of acquisition negotiations ended up in actual deals. they were reluctant to allow recontracting for fear of further deterioration in the capital adequacy ratio. Vol. or to agree on debt-equity swaps demanded by potential purchasers as a precondition for the deal. More important. while only 14 percent of the negotiations were completed from the beginning of the crisis up to April 1998. Involuntary Exits The Government has been involved in the restructuring process mainly through its supervisory capacity over banks.140 Corporate Governance and Finance in East Asia. Internationally. potential foreign buyers waited for the price of acquisition targets to come down further. Data collected by the Korean Chamber of Commerce and Industry show that the number of potential domestic and foreign buyers in the M&A market increased by about 50 percent over the six-month period from April to October 1998. the number of potential sellers decreased somewhat from 2.138 by the end of October. In their first review. 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. The reasons are manifold. 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. the creditor . Locally. banks and other creditors were reluctant to absorb losses realized by debt compositions. In many cases. because liquidation of debtor firms would exacerbate the banks’ already weak balance sheets. 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. II Divestitures to raise cash for debt reduction and to focus on core businesses have not proved to be easy.281 in April to 2.045 in October. FSC directed banks to appraise the long-term viability of client firms showing symptoms of failure.
These chaebols submitted plans for restructuring to improve their respective capital structures. three filed for courtsupervised bankruptcy reorganization. workouts are being applied to non-chaebol firms identified as financially weak. The plans were put into action immediately following finalization.Chapter 2: Korea 141 banks selected 55 firms as targets for exit. These included 20 firms from the top five chaebols and 32 from the top 6-30 chaebols. not only for the design of corporate workout programs but also their implementation. Among the sell-offs. the creditor banks drafted their own restructuring plans with assistance from outside advisory groups led by foreign investment banks. provided by the World Bank. Based on these plans. 24 were liquidated. Among the 55 firms selected. More than 200 financial institutions signed the Corporate Restructuring Agreement to carry out corporate workouts with the top 6-64 chaebols. interest reductions. and/or conversion of debt into equity have been applied to those firms that are considered to be viable in the long run and have voluntarily entered into negotiations with creditor banks. The workout plans were completed for most firms by early 1999. the results thus far have not entirely been as desired. Also. and 12 were sold off to other firms. creditor banks completed evaluation of the financial status of 35 subsidiaries belonging to 13 chaebols. write-offs. FSC has been monitoring the processes from a prudential regulation standpoint. By the end of 1998. . Corporate Workouts Workouts in the forms of debt rescheduling. two were acquired by newly organized employee stock ownership plans. A portion of the Technical Assistance Loan of $33 million. Upon completion of the evaluation. Negotiations were then held between the chaebols and the creditors’ councils to finalize the financial structure improvement plans. The creditor banks and the advisory groups also drafted such plans for the top 6-64 chaebols. and 16 non-chaebol corporations that had been selected as possible workout candidates. 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 their creditors. was allocated to the six largest banks for them to employ outside experts as advisors. 11 were merged into other group members. Although the intention of the Government and the banks was to effect immediate liquidation of these selected firms. but viable.
Big deals would. As of April 1999. In the case of automobiles. and equity participation—reached about $8. enable chaebols to streamline their overly diversified operations and focus on several core business areas. inducement of foreign direct investments was considered to be the most effective means of achieving that end. Big deals have been elevated to the status of the most important means of effective corporate restructuring. automobiles. Restrictions on foreign ownership of land were also abolished. oil refineries. On 3 September 1998. chaebols did announce their agreements on big deals in seven industries excluding the automobile industry. most of the big deals have entered their final stages of negotiation. the foreign buyer demanded specific protections against adverse developments in the business environment. the Government has been urging the largest chaebols to strike “big deals” or business swaps among themselves to consolidate overlapping manufacturing facilities. uncertainty over the future . However.142 Corporate Governance and Finance in East Asia. labor union demands of the seller were not acceptable to the transacting parties. railroad cars. In another. Foreign Acquisitions Confidence in the Korean economy depends critically on the lowering of the level of corporate debt. The less than satisfactory state of foreign capital infusion in the early days stems from a number of factors. Foreign investment—in the form of acquisition of controlling interests. aircraft. Hyundai Motor Corporation won the international auction of Kia Motors in its third bidding and Daewoo Motors agreed to acquire Samsung Motors. These deals could eliminate excess capacity in such industries as semiconductors. In one case. vessel engines.5 billion on agreement basis during the 10-month period after December 1997. some of the acquisition agreements have been discarded for various reasons. power plant facilities. This figure contrasts sharply with the total of $700 million for all of 1997. II creditor banks and the corporations will devise detailed workout programs based on the rehabilitation plans submitted by the corporations. Korea adopted and implemented policies to open its capital market completely. it is hoped. Big Deals Ever since the outbreak of the economic crisis. First. purchase of divested assets. and petrochemicals. Vol. Thus. In the early days after the outbreak of the crisis.
Seventh.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.Chapter 2: Korea 143 course of the Korean economy remains high. 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. many of the businesses that Korean firms put on sale did not prove to be attractive to foreign firms. the Government and chaebols reached an agreement on the goals of restructuring and reform efforts. Fourth. the improved procedures stipulated in the Bankruptcy Reorganization Act and the Composition Act reduced what had previously been legalistic exit barriers. (iv) to focus on a small number of core businesses. Sixth. (ii) to remove cross-guarantees of loans among group members. local creditor banks were reluctant to absorb losses arising from debt compositions and debt-equity swaps that were necessary in deals involving insolvent sellers. these goals were: (i) to enhance managerial transparency. foreign buyers were concerned with the inflexibility of the labor market. With this in mind. 2. Second. the widespread practice of cross-guarantees of loans and the lack of corporate transparency could potentially give rise to contingent liabilities to the buyer and this has posed a bottleneck problem to the speedy consummation of deals. and (v) to improve the accountability of controlling shareholders and the board. some of the potential acquirers demanded terms that were unreasonable or unacceptable from the sellers’ point of view. (iii) to reduce financial leverage. but it also has important implications with respect to corporate workouts. Not only does this represent progress in terms of an improved institutional framework for market competition. foreign buyers usually employed discounted cash flow methods of valuation while local sellers often put greater emphasis on replacement costs of assets. The presence of . Overhaul of Bankruptcy Procedures In February 1998.6. 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. Third. As set forth in the agreement. In effect. Fifth.
The court can refuse to accept the application for composition if it finds it inappropriate considering the size of corporate assets.” comprised of experts in the legal. number of creditors. Vol.01 percent in May 1998. the right to revoke court receivership is allowed to the creditors. Also. .144 Corporate Governance and Finance in East Asia. 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 an expeditious exit scheme is expected to better induce negotiation for workouts between creditor banks and corporations. a “Management Committee. accounting. and economics professions should be organized to provide for expeditious proceedings in court. Also. Third. Second. October 1998. the changes in the institutional setting for corporate reorganization will enable creditors and debtors to promptly respond to the development of financial problems. Korea’s Economic Progress Report. The purpose of this rule is to shorten the reorganization planning period. thereby preventing abuses by controlling shareholders/managers of financially distressed firms. (ii) legal changes have been made so that domestic accounting practices conform to international standards. the maximum grace period on loans to the firm being reorganized was shortened to 10 from 20 years. the Composition Act was amended to narrow the eligibility of applying for court-supervised composition. The changes in the reorganization procedures can be summarized as follows. Fifth. (iii) the representation requirement for shareholder derivative suits was drastically relaxed from 1 percent to 0. etc. the new rules made it clear that a court receivership order is available only when the going concern value of the firm under consideration is greater than its liquidation value. The creditors can form a “Creditors Committee” among themselves to allow them to participate in the decision processes in court. 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. First. In the past this stage usually extended for as long as two to three years. Fourth. (v) all listed companies are required to appoint outside directors beginning 1998 9 This and the following two subsections draw on the Ministry of Finance and Economy. the court may annul its previous decision and force the firm into immediate liquidation. (iv) restrictions on institutional investors’ voting rights were eliminated in June 1998.
Foreign Investment Promotion Act The Foreign Investment Promotion Act was put into effect in November 1998. administrative procedures for FDI will be dramatically simplified and made transparent. an additional nine industries will be opened or further liberalized. to FDI). Measures for improving standards in corporate governance are already effecting a generally more open corporate culture and greater transparency in business practices. Existing cross-debt guarantees should be completely eliminated by the end of March 2000. have been instituted for FDI: . 21 industries were further liberalized or newly opened to FDI (now. (v) by the end of May 1999. Foreigners are now able to invest in local bonds and short-term money market instruments without any restrictions. crossdebt guarantees totaling about W10 trillion—about 30 percent of the total guarantees among the 30 largest chaebols—were dissolved. According to the law. 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. 514 listed companies had appointed 677 outside directors). only 31 out of 1.148 industries remain closed. which was passed in August 1998. and (viii) as of 1 April 1998. As for promotion. either partially or fully. 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. In addition.Chapter 2: Korea 145 (as of the end of May 1998. These new standards are and will continue to be strictly enforced. various supporting measures. (iii) hostile mergers and acquisitions by foreigners were fully liberalized in May 1998. (vii) by the end of March 1998. (ii) full liberalization of foreign exchange transactions was legislated and will be put into effect in two stages. 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. (iv) during April and May 1998. (vi) bankruptcy laws were revised in February 1998 to facilitate the exit of insolvent firms. including financial subsidization. including tax exemptions and reductions. financial institutions could no longer require cross-debt guarantees. beginning on 1 April 1999. the Korea Trade and Investment Agency (KOTRA) will provide a one-stop service with respect to FDI. Capital Market Liberalization Since 1998.
the Government intends to supplement these measures with a sound macroeconomic policy in order to secure more effective protection against systemic risks. II (i) (ii) (iii) Tax exemption and reduction: Corporate and income taxes will be exempted or reduced for FDI in target industries. These bonds will be issued . the Korean Government is strengthening prudent regulations and market monitoring. Various support measures. Liberalization of Foreign Exchange Transactions In September 1998 the Foreign Exchange Management Act was replaced by the Foreign Exchange Transaction Act. Three-year government bonds will be used to establish a benchmark. The law allows rental cost exemptions and reductions for FDI. including infrastructure and tax support. It aims to establish a benchmark by consolidating various government bonds. such as the high-tech industry. The majority of government bonds to be issued in the next two to three years will carry a maturity of three years. Various local taxes will also be exempted or reduced for eight to 15 years at the discretion of local governments. however. Free Investment Zone (FIZ): A free investment zone will be developed to accommodate large-scale FDI. Also. These liberalization measures. for 10 years (full exemption for the first seven years and 50 percent tax reduction for the remaining three years). Vol.146 Corporate Governance and Finance in East Asia. To minimize potential risks. are not risk-free. Capital Market Augmentation Bond Market The Government recently introduced a policy plan to deepen Korea’s bond market. Low cost rental facility: National and public real properties will be rented to foreign-invested firms for up to 50 years. as well as building an early warning system. will be provided to foreign firms in the FIZ. The location of the FIZ will be determined at the request of foreign investors. The primary aims of the law are the liberalization of the capital account and the development of the foreign exchange market.
As a pilot program. a primary dealers system will be introduced for healthy financial institutions. In August 1998. to establish closed-end investment companies. Asset-Backed Securities A new law providing for asset-backed securities (ABS) was passed in September 1998. Mutual funds (or open-end investment companies) will be allowed starting 2001. The Government established specific qualification criteria and selected the primary dealers in 1999. In order to promote a greater market demand for government bonds. No qualification requirements are being imposed on investors who are sponsoring new mutual funds. invested a total of W1.6 trillion for the debt restructuring fund.Chapter 2: Korea 147 monthly. It also opened the credit rating service market to foreign competition. If interest rates stabilize at a low level. Moody’s signed a joint venture contract with Korea Investors Service. and the demand for longerterm bonds increases in the future. commercial banks were allowed to carry out dealing operations for government bonds starting in October 1998.6 trillion in these funds: W0. These are expected to operate for the next three years. Twenty-five domestic financial institutions. the Government will correspondingly expand the issuance of government bonds that have a maturity of five years or more. 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. and W1 trillion divided equally between the three balanced funds. but may be extended as required. Prior to the introduction of this system. Related legislation was put into effect in September 1998. a debt restructuring fund and three balanced funds (funds that invest in both equity and debt) were established in September 1998. To ensure transparency and efficiency of the fund operations. they will be managed by foreign investment management companies. with only minor standard exceptions. and is promoting joint ventures between foreign and domestic agencies. This law will not only provide an effective institutional environment for the disposal of NPLs. but it will also help improve financial institutions’ risk management. including the Korea Development Bank. It is now easy for private investors. both domestic and foreign. financial institutions . According to the law.
6. A investing in B. this can only be a temporary measure. foreign business corporations with good credit standing are now also permitted to issue ABS. However. It would be more desirable for the market-oriented measures to be put into place and strictly enforced. One way of strengthening independence of the boards is to require that listed companies accept nominations for directors by institutional . A good governance system is essential for the healthy growth of corporations and financial institutions. Direct controls of interfirm investments and/or pyramidal ownership structures will not be persuasive.. unless the limit is tight and binding. this regulation may not be effective in curtailing pyramidal structures. as stipulated by the government measure. II and qualified public corporations. The corporate governance structure cannot be expected to function efficiently if this issue is not addressed. Vol. can utilize ABS. etc. For instance. 2. B investing in C. However. Selfdealings. and C investing in D. However. On the other hand. which is the case for many chaebols.) and the level of interfirm investments is very high.3 Policy Recommendations Poorly performing markets and the resulting lack of market discipline justified the government intervention in recent corporate and financial restructuring activities. there is another view that placing a maximum limit on interfirm investments. such as the Korea Asset Management Corporation (KAMCO). is inevitable. when the limit is binding. considering that there is no other effective way to limit circular investments among chaebol affiliates (e. In principle. the government intervention will have to be refocused so that it only sets the rules of the game in the marketplace. then the regulation will inhibit efficient investment of firms. greater efforts to improve corporate governance are preferable to regulation of interfirm investment. More important.g. Policies aiming to improve the corporate governance system should take into account the high ownership concentration often created by pyramiding.148 Corporate Governance and Finance in East Asia. 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. 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. There must be stronger rules to control agency problems. the role of the board of directors as the internal control mechanism must loom large in corporate governance. As markets become more efficient. cross-subsidization.
Listing rules may recommend that all or large listed companies adopt an audit committee. pp. 1997). Each listed firm should be required to disclose the extent of its compliance with the Code in its annual report. 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. Institutional investors will play an increasingly important role in corporate governance. One action that has yet to be taken is the introduction of an act to facilitate class action suits against corporate directors and internal and external auditors for their wrongdoings. The Corporate Board. using audit. governance. September/ October 1997. the Korea Stock Exchange could incorporate provisions of the Code of Best Practice in Corporate Governance in its listing rules. 1997. The Government can prompt institutional investors to contribute more to good corporate governance by paying greater attention to corporate affairs. and other committees. The Securities and Exchange Act will then require large listed companies to switch to a board audit committee system from an internal auditor system. Since the economic crisis. Latham. various measures have been implemented to promote investors’ rights. 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. thereby helping to strengthen board independence and enlisting boards’ more active involvement in monitoring corporate management. More effective measures to protect investors will enhance corporate transparency and also the accountability of directors to shareholders. Proposed: A Governance Monitor. Class action suits are an efficient means for corporate monitoring. 23-26. Further.Chapter 2: Korea 149 investors or their trade associations. If and when the law is introduced. and requiring that all directors hold shares of their companies. The annual shareholders meetings could also elect reputable “monitoring companies” to recommend director candidates (Latham. The Government has already announced that it intends to amend the Commercial Code to introduce Anglo-American type audit committees as an alternative to the current internal auditor system. One way of motivating institutions to do this is to 10 M. . it will have to include making self-dealings by directors and officers. 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.
insurance companies. In the coming years. Another measure. and compliance officers. an audit committee. and other NBFIs are subsidiaries of chaebols— especially the five largest ones. Shareholdings concentrated in investment companies and other institutional investors pose a serious dilemma. Also. The Government recently proposed the revision of bankruptcy-related laws. Vol. possibly. etc. Rights of minority shareholders should also be strengthened for these institutions. 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. 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. by all nonfinancial companies (or “industrial capital”). 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. II provide comprehensive guidelines for their actions in matters related to corporate governance. such as the Korea Investment Trust Association. could prepare such guidelines. 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. and impose stronger penalties on violations of the rules on portfolio investments. is to restrict ownership of investment trust companies and NBFIs by the five largest chaebols and.150 Corporate Governance and Finance in East Asia. Many of the larger investment trust companies. 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. the Government will have to come up with appropriate policy measures to solve these problems. objecting to certain defensive measures proposed by the management. more drastic in nature. and thus cannot be expected to be actively involved in monitoring portfolio firms. securities companies. The institutions’ respective trade associations. reviewing independence and expertise of candidates for outside directors. Application of more stringent bankruptcy-related rules to firms in financial distress will effect greater discipline over corporate management. . strengthen its supervisory activities. These guidelines would recommend shareholder activism and faithful discharge of fiduciary duties by actively participating in shareholder voting. The Government can also lower the limits on investments in affiliated companies. strengthening incentive compensation schemes for executives.
lessening the degree of double taxation of dividends (or further reducing personal income taxes on dividends). to concentrate instead on a small number of core businesses. The current obligatory system of disclosure that emphasizes “hard” . and consistently show low profit rates.Chapter 2: Korea 151 There still exist widespread concerns that the Government will continue to exercise a great deal of discretionary power over banks. through them. and thus full-scale education programs should be developed. reduction of protection of domestic markets and entry barriers. This means that the Government can control the banks and. The Government should put more efforts into developing the capital market. In order to minimize government intervention in bank and corporate management. excessively diversified into nonrelated business areas. An effective policy package is needed for chaebols to dispose of marginal firms with low profitability at the earliest date. and (iii) a good corporate governance system to protect investors. the limit on ownership of bank shares will have to be eased so that strategic investors (shareholders) can act as true effective monitors of bank management. private firms. the important issues to be addressed are: (i) improvement of the corporate disclosure system. The public and corporations should be taught or fully informed of the best practices in corporate governance. Many concepts regarding good corporate governance are still new to a lot of market players in Korea. which could provide alternative sources of long-term corporate finance. such as application of higher interest rates by banks to chaebols with higher DERs. (ii) provision of reliable accounting information. For this. Many corporations are burdened with excessive debt and. Chaebols are overly indebted. large firms. To facilitate the development of the Korean stock market. Such measures include providing an effective corporate governance system. Banks need to play a bigger role than they do at present in monitoring corporate investment and management. Banks should adopt strong incentive compensation schemes for management. therefore are vulnerable to economic shocks. and introducing disincentive schemes for excessive borrowings. The Government should substantially reduce the proportion of policy loans from bank loans. and stop unfair internal transactions. The Government needs to sell off at the earliest feasible dates the bank shares that it acquired in the course of recapitalizing banks. and financial institutions. Bank boards also need to be made more independent from management. bank managers should be made accountable to shareholders but not to the Government. In turn. the banks have great leverage over the management of debtor firms. the elimination of implicit guarantees for financial support to chaebols.
152 Corporate Governance and Finance in East Asia. is considered to be one of the major causes of the economic crisis. II information on past performance needs to be transformed into a system in which corporations voluntarily announce “soft” information on future prospects. reasons for different degrees of corruption in various countries. no economic reforms will be effective. Currently. Overvaluation of exchange rates should be avoided in order for export and import-substitution industries to stay internationally competitive. Policies are needed to help develop more reliable services by bond rating agencies. The function of securities companies as dealers of bonds should be improved. Without successfully addressing this problem. the information system of the bond market should be better organized to transmit. The development of the OTC bond market requires a well-developed dealer system. and measures to reduce corruption. These should be lengthened to make them a source of stable long-term funds. Future research could include causes of corruption. One of the significant changes in the bond market after the economic crisis is that most corporate bonds are now issued nonguaranteed and on the basis of credit quality of the issuer. In determining optimal exchange rates. on a real time basis. data on quotations and trading volumes. More effective punitive means need to be devised to penalize both corporations in violation of disclosure rules and the officers in charge. politicians. Prevalent corruption. Another problem with the corporate bond market is that most bonds are issued with maturities of less than four years. . penalties on violations of disclosure rules are not effective enough to have a significant impact. At the same time. The network should cover not only the exchange market but also OTC transactions of investors and dealers. The establishment of a Corruption Prevention Institute will be helpful in this regard. profitability of export industries and real effective exchange rates that account for changes in nominal exchange rates. especially among business people. wage rates. and labor productivity should be considered. Vol. and bureaucrats. Maintaining current account surpluses for a considerable period is needed to pay back foreign debts.
KERI. The Corporate Board. N. 1992. and H. C. 1998. T. Cho. S. 1996. Corporate Restructuring. Chung and H. 1997. Latham. Bank of Korea. M. H. Determinants of Diversification of Korean Business Groups. Hattori. and J. 1997. edited by K. 1997. various issues. September 1998. Kwon. 1999. Kang. 1989. W. K. September 1997. Lee. various issues. Kim. Chon. Center for Free Enterprise. Financial Studies. Chon. various issues. Proposed: A Governance Monitor. September 1998. I. Lee. pp. Jae Woo. S. 1989. W. Korea’s Financial System. pp. Y. New York: Praeger.Chapter 2: Korea 153 References Bank of Korea. S. 79-95. September/October 1997.). Bank of Korea. A Study on the Relationship between Ownership Structure of a Firm and Value of a Firm. Kim. Bank of Korea. Evolutionary Chaebol. S. 1994. H. Financial Studies. Korea Development Bank. KERI. C. 1995. KERI. Ju Hyun. Lee. W. . Korea Economic Research Institute.. Korea Economic Research Institute. 1995. Hong. International Monetary Fund. D. Hong Moon Sa.. C. Chung. International Financial Statistics. Korea’s Chaebol. H. H.. Korean Managerial Dynamics. Tomio. in Korean Managerial Dynamics. Korea’s Large Conglomerates. 7995. Lee (eds. 1996. 1997. An Empirical Evidence on Value of a Firm and Ownership Structure. Maeil Daily Economic Newspapers. 1998. 1996. 23-26. Choi. H. Economic Statistics Yearbook. 1993. Cho. K. various issues. Jua. Understanding Flow of Fund Accounts. Kim. Financial Statement Analysis Yearbook. D. New York: Praeger. S. I. Market Concentration and Diversification of Business Groups. S. Bibong Publishing Co. Survey of Facility Investment Plan. W. and K. pp. Is the Fair Trade Policy Fair? Korea Economic Research Institute. and 1998 issues. Japanese Zaibatsu and Korean Chaebols.
. I. H. Lee. Management Research Institute. A New Trade and Industrial Policy in the Globalization of Korea. Nam. J. J. Kim. Chung Ang University. Real Exchange Rate and Policy Measures. Ungki.154 Corporate Governance and Finance in East Asia. S. . Corporate Governance in Korea. 1998. Kim. KIEP Working Paper 98-05.. Lim. 1995. 1998. November 1996. Vol. Ministry of Finance and Economy. S. Annual Conference of Financial Management Association. Capital Liberalization. S. Sohn. and H. U. Chicago. 1998. Korea’s Trade and Industrial Policies: 1948-1998. 1999.. Seoul. 2nd Sangnam Forum. 1999. Joh. C. Yang. S. September 1998. Lim. 1996. and J. K. H. W. Korea Development Institute and World Bank. C. Lee. 1996. Y. K. Background and Task of Structural Adjustment. Conference on Corporate Governance in Asia: A Comparative Perspective. Korea Institute for Industrial Economics and Trade. The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols. Korea Institute for International Economic Policy. KIET Occasional Paper No. II Lee. October 1998. The Pattern of Ownership Structure and their Characteristics in Korean Conglomerates: With Cases of the 30 Largest Chaebols. March 1999. Korea Institute for International Economics and Trade. and J. Whang. October 1998. Korea Finance Institute. Yonsei University. K. Yim. Korea’s Economic Progress Report. Y. Wang. J. January 1995. Kang. Beyond the Limit. Y. 23. 1998. Whan. Ungki. I. Business Groups in Korea: Characteristics and Government Policy.
Inc. after the completion of debt negotiations with the IMF and Paris Club. Pineda. aiming at eventually limiting the Government’s role to economic policy setting and allowing the private sector to conduct most economic activity. When the Asian crisis erupted in 1997. 1 Principal. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. This has come about following a political and economic upheaval from 1983 to 1987. . overall. Companies of other Asian countries were already using these markets to finance investment and growth.1 Introduction In recent years. The Asian financial crisis revealed that. for their research assistance. Roble.3 The Philippines Cesar G. the Philippine economy and corporate sector were in a relatively sound financial position. Issues such as State ownership of businesses. the Philippines. the Philippine Stock Exchange for its help and support in conducting company surveys. David Edwards. 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). PSR Consulting. and government subsidies were tackled during that period. the Philippine nonfinancial corporate sector had managed its borrowing risks relatively well by largely avoiding imprudent use of debts and risky investments. Inc. both of ADB. and Liza V. staff. the PSR Consulting. healthy profits from the previous five years and new equity raised through successful initial public offerings (IPOs) in a robust stock market allowed the corporate sector to accelerate investments and borrowings. From 1993 to 1996. about a decade before the recent Asian crisis. Saldaña1 3. Serrana. allowed the Government and the corporate sector to gradually access foreign debt markets after a long absence. in particular Francisco C. state-sanctioned monopolies. the Philippine corporate sector has played a leading role in the government’s efforts to get the country on track toward sustainable economic development. Denise B.. The lifting of the debt moratorium in 1991. and Lea Sumulong and Graham Dwyer for their editorial assistance. The author wishes to thank Juzhong Zhuang.
their growth could not be sustained. To implement these policies. It analyzes the impact of corporate governance on company financial performance and financing. 3. therefore. patterns of ownership. which leads to their easing of due diligence and monitoring standards when lending to group members.2 3. Vol. Investments of large corporate groups tend to focus on obtaining market shares and industry dominance. the corporate sector showed structural weaknesses similar to those in neighboring Asian countries. While new manufacturing industries were successfully established. Banks have significant presence as members of affiliated business groups. control by internal and external governance agents. These early industrialists naturally opposed any initiative to reduce tariffs. II Still. and on the financial crisis. regulatory framework. But protectionist policies made labor relatively more expensive and. Companies were profitable because of protection from foreign competition. The Board of Investments (BOI) was created to draw up an investment priorities . composed mostly of families previously in trading businesses. Companies finance long-term investments with short-term debt.1 Overview of the Corporate Sector Historical Development During the 1950s and 1960s.2. nationalist sentiments led to policies that favored import substitution and heavy government intervention in business. usually with the acquiescence of bank creditors. This study reviews the Philippine corporate sector in terms of its historical development. Sugar refining and textile mills are examples of industries that floundered in the 1980s because of government import substitution policies. An industrial elite. on family-based and controlled conglomerates. and responses to the financial crisis. companies were necessarily large and capital-intensive. patterns of financing.156 Corporate Governance and Finance in East Asia. The highly concentrated and family-based ownership of corporate groups has resulted in governance structures that depend largely on internal control systems. emerged to influence industrial policies. the Government overvalued the local currency and imposed high import tariffs. yet they did not risk new capital required for modernizing and expanding manufacturing capacity. Corporate financing relies excessively on bank loans. Government interventions under the notion of “master planning” for economic and social development characterized the 1970s and early 1980s. The policy was crafted by the martial law regime at that time.
Starting in 1981. Better access to cheaper imported raw materials improved the competitiveness of local manufacturers. The 1980s were marked by a peaceful transition of political power. 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. Reforms in policies. advance notice of areas where the country disallowed or restricted foreign investment. the legislative body passed the Foreign Investment Act (FIA). 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 . assumed ownership of the largest petroleum refining company.Chapter 3: Philippines 157 plan (IPP) to encourage private sector investments by offering tax and other incentives. In 1991. dominance by large companies. including the reduction of tariffs. quantitative restrictions. It limited the bureaucratic cost and discretion that accompanied the necessary approvals of foreign investments. the top three companies accounted for a disproportionately large share of total sales and assets. and orientation toward domestic markets. The FIA allowed foreign equity investment in many areas and at the same time provided a transparent. the State took over the generation and distribution of electricity. and oriented toward exports. Following government initiatives in the control of the infrastructure and utilities sectors. the Government continuously revised the enabling law of BOI so that incentives were reduced in number. and initiated the development of alternative energy sources in response to the oil crises. i. BOI incentives retained a strong bias in favor of capital-intensive enterprises and domestic-oriented industries. In many industries. Foreign ownership was allowed only in industries with high technological and market barriers.” No strategic industry could take off without the Government’s participation in its management and operations. Exports were not competitive because of the high costs of imported materials. made less associated with capital investments. Nevertheless. the Government narrowed the range of tariff rates by commodity categories and reduced the average tariff rate from 28 to 20 percent. clearly shifted economic management toward reliance on markets rather than on decisions by bureaucrats in the Government. the “pioneer” industries identified in the IPP.e.. organizing industries into sectors and picking “winners. and import licensing requirements. Quantitative restrictions and tariff protection of preferred industries remained firmly in place. In the early 1990s.
3. .2 Source: ADB. Key Indicators of Developing Asian and Pacific Countries 2000.5 9.0 (6.2). only nonfinancial companies were used.8 4. Rep.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 1.7 5.1 5.5 8.2) 4.7 8. The Philippines substantially lagged behind other countries from 1990 to 1995 (Table 3. competition from liberalized imports had somewhat reduced oligopolistic tendencies and concentration in many industries.2.7) (10.7 (13.0 8.0 (0.9 (1.8 5. Its growth rate began to catch up with others in 1996.3 9.5 percent per year (Table 3.4 4.8 5.3 7. This rate of growth was sustained by a comparable 18.3 2.6) 0.8 8.8 8. II market.9 5.8 10. only to be unsettled by the crisis of 1997.8 percent growth in fixed 2 The SEC-BusinessWorld Annual Survey of the Top 1. With economic reforms introduced in the 1980s and 1990s.6 7.5 8.3 9.9 6.2) 0.2 7. of 9.1). Table 3.5 (7.2 Thailand 11.5) 3.1 8.2 7.5) 5.0 8.000 corporations.000 Corporations covers financial and nonfinancial companies. 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.000 Philippine companies grew 17. which was taken as a representation of the Philippine corporate sector.2 8. In this section. net sales of the top 1.4 Philippines 3. Vol.3 8.7 Malaysia 9.2 During 1988-1997.2 9.2 (0. 1990-1999 (percent) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Indonesia 9.1 4.2 Korea.9 7.7) 10.158 Corporate Governance and Finance in East Asia.1 5. however.0 7.1 GDP Growth of Southeast Asian Countries.
4 1.9 1.2 Indicators 1988 Growth Indicators (P billion) Net Sales Net Income Fixed Assets Total Assets Total Liabilities Stockholders’ Equity Retained Earnings 464.4 63.2 136.2 Growth and Financial Performance of the Top 1.4 8.5 1.5 72 7.3 306.5 Leverage = total liabilities/stockholders’ equity.4 898 1.9 2.1 Other Indicators No.123. of Companies Sales per Company (P billion) 899 0.8 4.000 Corporations in the Philippines.4 Financial Ratios (%) Leverage ROE ROA Turnover Net Profit Margin 222 14.512.1 615.3 941.8 5.2 707.1 1.5 51 4. return on assets (ROA) = net income/total assets.3 898 1.0 900 1.7 73 6. net profit margin = net income/net sales. Source: SEC-BusinessWorld Annual Survey of Top 1.978.5 446.9 617.893.8 411.225.1 5.7 28.1 51.7 20.2 27.6 1990 1991 1992 1993 1994 1995 1996 1997 1.3 68 7.9 149 6.160.4 602.9 480.6 75 6.697.5 192.2 Average 146 12.5 1.6 109 12.0 148.6 896 0.5 193.2 378.9 629.8 902 1.5 570.6 149 12.1 72.9 896 2.6 1.394.9 3.341.2 2.5 119 12.5 887 0.2 4.3 121 12. turnover = net sales/total assets.2 Compound Growth (%) 17.561.4 861.209.4 776.6 18.2 900.1 1.1 66 12.9 96.8 6.7 1.000 Companies.5 14.1 881.5 64.131.6 144.1 33. 1988-1997 1989 519.1 4.1 714.5 4.0 1.9 898 1.3 107 13.1 54 11.2 1.9 78 6.4 260.1 95.7 903 0.4 3.1 181 11.7 238.8 618.3 382.6 954. .8 22.1 197 14.647.1 73 184.108.40.206 77 7.781.5 1.3 60 10.5 508.6 102 16.3 46.0 1.6 426.317.6 35.6 5. return on equity (ROE) = net income/ stockholders’ equity.7 443.8 741.1 468.4 411.3 862.1 6.332.6 290.Table 3.2 2.6 900 1.4 188.4 555.7 1.9 952.2 338.8 26.7 218.
9 21.4 24.352 1.8 19.6 percent and 5.1 19. This is high compared with developed countries but compares favorably with other Asian countries.1 Net Sales (P billion) 465 519 630 741 862 954 1.178 1. and the SEC-BusinessWorld Annual Survey of Top 1.8 percent per year. Net profit margins for the top 1. These rates of return are high compared with other Asian countries. Further. Return on equity (ROE) and return on assets (ROA) averaged 12.000 Corporations in the Philippines.474 1. and by equity that grew at a higher average annual rate of 26. Assuming Table 3. indicating that the corporate sector’s exposure to foreign currency-denominated loans was not as significant as in other countries.9 23. for the 10-year period.427 13. but the extent of the increase was not as dramatic as in other Asian countries. 1988-1997 Top 1. II assets.5 17. various years.5 16. Net income consistently increased from 1988 to 1996 and declined only in the crisis year 1997.172 2.9 percent for the period.2 percent.3 The Corporate Sector and Gross Domestic Product. Key Indicators of Developing Asian and Pacific Countries 1999. .906 2.5 Value-added is assumed to be 30 percent of net sales. leverage increased from 109 percent in 1996 to 149 percent in 1997.3). respectively. The data suggest no evidence of excessive borrowing in the run-up to the crisis in 1997.697 1. Asset growth was funded by debt that grew at an average of 20.000 companies averaged 7. Vol. The debt-toequity ratio ranged from 222 percent in 1988 to 102 percent in 1994.8 17.077 1.4 20.394 1.3 percent.000 Companies Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average Growth (%) a GDP (P billion) 799 925 1.693 1. Total assets grew at an average annual rate of 22. Sources: ADB.7 percent.160 Corporate Governance and Finance in East Asia.248 1.979 17.5 Ratio of Estimated Value Addeda to GDP (%) 17. The growth rates of corporate sales for the period 1988-1997 exceeded those of the country’s GDP for the same period (Table 3.
3 42.2 103 5.1 22 10.8 percent of the corporate sector’s total sales between 1988 and 1997. %) 17.4 28. .4 Growth and Financial Performance of the Corporate Sector by Ownership Type.7 22.0 4.3 27. Averaging 42.0 5.8 ForeignOwned 21.9 158 13.8 22.5 23 4.5 GovernmentOwned 4. The premise is that these variables have a direct bearing on corporate performance and growth.4). these figures suggest a significant and increasing contribution of the corporate sector to GDP.3 146 6.8 3.5 27.1 Financial Ratios (%) Leverage 89 ROE 15.1 12.5 Retained Earnings 30. size.5 Source: SEC-BusinessWorld Annual Survey of the Top 1. privately owned companies constituted the largest group (Table 3.000 Corporations in the Philippines. 1988-1997 Indicators Publicly Listed Privately Owned Rate.8 14.Chapter 3: Philippines 161 a constant ratio of value added to sales.9 196 1. and (iv) privately owned. various years. (iii) Government-owned.9 17. Performance by Ownership Type The Philippine corporate sector can be categorized into four groups based on ownership: (i) publicly listed. (ii) foreign-owned.0 142 22.3 22.3 11.8 No.3 9.8 606 0.6 Total Assets 29.0 Net Income 19.4 190 5.8 2.0 31.4 Fixed Assets 19.2 9. corporate control structure.1 ROA 8.0 28. of Companies 73 Sales per Company (P billion) 2.9 26.7 2.5 Other Indicators Share of Sales (%) 17.8 Growth Indicators (Compound Annual Growth Net Sales 20. A study of company performance by ownership type.0 5.9 22. and industry reveals further structural characteristics of the growth and financial performance of the corporate sector.0 Turnover 53 Net Profit Margin 15.4 Total Liabilities 26. The foreign-owned companies were the Table 3.4 Stockholders’ Equity 32.3 22.
162 Corporate Governance and Finance in East Asia. Their ROA and ROE were both more than twice as high as those of government-owned companies.1 billion per company in 1997. However. meaning that the remaining 62 percent were relatively small in sales and assets.2 percent and ROA of 9.5 percent average growth rate of the entire corporate sector. But by being most efficient in employing assets. Publicly listed companies had the lowest leverage at 89 percent.9 percent. the second best ROE and ROA. and low return on investment is the norm. the highest net profit margin of 15. these companies were comparatively large. but lower than those of foreignowned and publicly listed companies. they generated the highest return on investments. followed by publicly listed ones. were among the top 1.000 list. exceeding the 17. With an average leverage ratio of 142 percent. Publicly listed companies had a minor though steadily increasing share in total sales. Governmentowned companies in the top 1. a level high by Western standards but at par with those of other Asian countries. the asset base is large. II second largest at about 27. The privately-owned companies had a high average leverage ratio of 158 percent. and the second lowest asset turnover. selling an average of P4. although small in number. compared with P2.000 companies in 1997. . Vol. Privately-owned and Government-owned companies grew at slower rates. foreign-owned companies borrowed more than publicly listed ones. while there were few of them. 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. Bases Conversion Development Authority.3 percent.75 billion per company for foreign-owned companies. and government-subsidized agencies such as the National Food Authority and Local Water Utilities Administration. with an average ROE of 22. 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. or 38 percent.8 percent for foreign-owned companies and 20 percent for publicly listed companies during 1988-1997.5 percent. These were mostly large public utilities. registered the largest per company sales at about P9 billion in 1997. The compound annual sales growth rate was 21. The privately-owned companies were only about one third of the average size of per company sales of the publicly listed companies. reflecting the significant presence of holding companies as the gross revenues of holding companies flow through to operating income.
various years. Table 3.8 ROA 8. But the conglomerates were larger measured in sales per company.3 Other Indicators Share in Sales (%) 32.0 25.0 Turnover 67 Net Profit Margin 12.7 Total Assets 32.0 166 15.1 124 5.000 Corporations in the Philippines.6 715 0. the corporate sector is divided into large.0 22.3 No. and small companies. and achieved higher returns on invested assets than independent companies (Table 3.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. depending on assets and sales.2 Fixed Assets 25. Performance by Firm Size By firm size.0 55.5).1 Source: SEC-BusinessWorld Annual Survey of Top 1. medium.7 Stockholders’ Equity 34. %) Net Sales 20. of Company 159 Sales per Company (P billion) 2. 1988-1997 Indicators Group Member Independent 18. grew faster.3 Total Liabilities 30.3 percent for the conglomerates. had a lower leverage ratio.2 23. a company can be a member of a conglomerate or independent.7 2.1 Retained Earnings 32.6 26. compared with 32. Sales and resources of the .2 Net Income 21.8 6.5 Growth and Financial Performance of the Corporate Sector by Control Structure.8 Growth Indicators (Compound Annual Growth Rate.3 Financial Ratios (%) Leverage 98 ROE 15.4 24.
2 Stockholders’ Equity 18. while small companies.6 Small 19.9 Retained Earnings 13.0 32.4 28. are defined as the largest 100 companies in the top 1. Medium-sized companies.6 31. which.9 Financial Ratios (%) Leverage 158 ROE 13.1 ROA 5.2 29.6 36.9 26.2 25. averaged a far less P3 billion in per company sales.2 Other Indicators Share in Sales (%) 56.0 156 16.1 4.000 list. averaged only P920 million in per company sales during the same year.0 730 0.3 Fixed Assets 15.7 Net Income 1.7 44.6 47.5 128 10.3 Turnover 65 Net Profit Margin 8.1 25.1 No.5 Total Assets 18. of Companies 79 Sales per Company (P billion) 7. Table 3. 1988-1997 Indicators Large Medium 19.3 Source: SEC-BusinessWorld Annual Survey of Top 1.000 list.5 73 6.5 12. However.6 Growth and Financial Performance of the Corporate Sector by Firm Size. sales of mediumsized companies grew faster than large companies.5 25. Sales per company in this group averaged P13. although they comprised only 8.164 Corporate Governance and Finance in East Asia.1 percent of the total sales of the corporate sector. . Medium-sized companies also performed better in terms of ROE. indicating that they deployed resources more efficiently than large and small companies. II Philippine corporate sector are highly concentrated among the large companies. %) Net Sales 15.6).9 32. various years.4 Total Liabilities 18.5 Growth Indicators (Compound Annual Growth Rate. Large companies accounted for 56.0 7. defined in this study as the next 200 largest companies in the top 1.8 percent of the total number of companies in the list (Table 3. for this study.6 49.1 81 9.4 billion in 1997.000 Corporations in the Philippines.9 89 1. averaging 16 percent. Vol. referring to the remaining companies in the list.
and construction. i. but lower than that of construction. compared with 9. as indicated by the negative annual growth. reflecting to some extent a “bubble” phenomena in the former two sectors. with their ROE dropping to 3. profits. at -12. Poor returns appear to have been caused by the low profit margin at 6.7 billion and P35. manufacturing. unlike their counterparts in other Asian countries.7. and assets was much higher for the real estate and property. averaging 10.2 percent for large ones. Medium-sized companies apparently enjoyed efficiencies associated with economies of scale and made more productive use of their assets.7 percent in 1996 to 8.2 billion in 1997 for this sector. showed the lowest ROE. The leverage ratio of the manufacturing sector was higher than that of the real estate and property sector. real estate.1 percent. Mediumsized companies’ leverage level was slightly lower. For small companies.e.Chapter 3: Philippines 165 Small companies.1 billion in 1996 to P4.8 billion in . The Asian financial crisis affected large companies most severely. utilities. at 156 percent.7 percent a year earlier. Net income declined from P54. net income. from 14.. at 128 percent for the period. and profitability in 1997 when the crisis started. and the construction sectors than for the manufacturing. and equity up to 1996. net income. of net income.8 percent in 1997. The real estate and property sector also suffered significantly in sales. although the largest in number. are shown in Table 3. specifically those industries least and most affected by the financial crisis.6 percent. The growth and financial performance of selected industries. Manufacturing companies represented more than half of the corporate sector in number in the period 1988-1997 and accounted for about 82 percent of total sales.8 the previous year.4 percent in 1997 from 11.7 percent in 1997 for medium-sized companies. but suffered its largest decline in net profits in 1997. ROE dropped from 10. Growth of sales. assets. Large. But small companies’ leverage was significantly lower. and utilities and services sectors. and utilities and services sectors. at 158 percent on average during 1988-1997.5 percent for medium-sized companies and 8. Performance by Industry This study also looked at corporate performance by industry. especially during the period 1994-1996.8 percent. ROE dropped to 7. Sales revenue and net income declined from P76. Leverage was the highest for large companies. The sector showed consistent growth in sales.and medium-sized companies did not substantially increase their leverage in years running up to the crisis in 1997.
8 48.3 Fixed Assets 20.000 Corporations in the Philippines. Its knock-on effect on the economy was small as it accounted for less than 3 percent of the top 1. II Table 3.9 23.4 Source: SEC-BusinessWorld Annual Survey of Top 1.3 5.5 Other Indicators Share in Sales (%) 82. 1996 to P56.7 billion in 1997.6 Financial Ratios (%) Leverage 142 181 ROE 13.6 Growth Indicators (Compound Annual Growth Rate.7 Growth and Financial Performance of the Corporate Sector by Industry.7 Net Income (12. As a result.2 8.1 10. the sector’s ROE dropped from 15.7 10.4 19.1 2.9 2.3 20. 1988-1997 Utilities Real Estate and and Services Property 39.9 5.8) 17.7 52.4 16.6 No.2 37.000 companies’ total sales on average during 19881997.0 25. With a modest increase in total liabilities and leverage level of less than 100 percent in 1997.4 Total Assets 19.3 55.2 28 0.0 23. %) Net Sales 16.0 Turnover 112 24 Net Profit Margin 5.9 2.1 24 42. and was also much more limited compared with the property sectors in other Asian countries.9 17. .7 percent to 10.7 28. it does not appear to have been excessively exposed to foreign currency-denominated loans.4 3.7 Indicators Manufacturing Construction 27.9 billion and P24. various years.2 12. of Company 454 17 Sales per Company (P billion) 1.166 Corporate Governance and Finance in East Asia.7 19. respectively.3 Retained Earnings 17.7 ROA 5. The sector’s buildup in equity during the stock market boom of 1994-1996 may have cushioned the impact of the crisis. Vol.7 192 9.8 41.4 percent.6 69 16.8 Stockholders’ Equity 21.5 12.0 21.7 83 2. But the impact of the Asian crisis on the real estate and property sector was much smaller than that on the manufacturing sector.6 Total Liabilities 18.2 45.0 31 0.
and dissolution of corporations. par value. the ownership of Filipino citizens in the corporation is not less than the legally required percentage of capital stock. Corporation Code of 1980 Supplanting the old Corporation Law of 1906. the leverage of all four industries was low. the Corporation Code of 1980 is a compilation of important juridical rulings. It provides the basic constitutional structure for the organization. .2. the Revised Securities Act (RSA) and PSE’s public listing requirements also apply. administrative regulations. and amount of authorized capital stock. contains some provisions affecting corporations’ dealings with banks. nationalities. (v) number of directors (not less than five nor more than 15). It specifies the minimum information to be indicated in the articles of incorporation. and the Insolvency Law. The currency devaluation bloated the foreign currency-denominated loans of these companies. the Code requires a corporation 3 A company’s articles of incorporation should include: (i) corporate name.Chapter 3: Philippines 167 The utilities sector had the second highest leverage during 19881997 at 181 percent on average. (vi) names. 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. One month after registration. nationalities. and residences of incorporators and directors. which regulates banks and nonbank financial institutions except insurance companies. Under the Code. and amount subscribed and paid by each. unlike in neighboring countries hit by the Asian crisis. The General Banking Law. (iv) term of existence. and restrictions.3 Legal and Regulatory Framework The Corporation Code of 1980 is the main law governing the corporate sector. 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. For publicly listed companies. and residences of original subscribers. which is also the organic law governing the operations of SEC. which was based on American corporate law. and recognized rules on corporate practices. (vii) number.3 which serve as the company’s declaration that the minimum percentage of authorized capital required by law has been subscribed and paid-up. 3. reaching up to 313 percent in 1997. (ii) purpose of the corporation. Two other pertinent laws are Presidential Decree (PD) 902-A. privileges. operation. (iii) principal office. and (viii) names.
(iv) time for holding annual election of directors and manner of giving the election notice. and reasonable. 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. shareholders may delegate this power to the board of directors by a two-thirds vote of outstanding capital stock. (ii) required quorum in shareholders’ meetings. Vol. duties. manner of voting. between the shareholders and the corporation. In 1976. and control (adjudicative) of all corporations. and (vii) manner of issuing certificates in the case of stock corporations. directors. officers. among shareholders.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. and compensation of directors. 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. (vi) penalties for violation of the bylaws. . Its mandate is to supervise corporations in order to encourage investments and protect investors. (v) manner of election or appointment and term of office of all officers other than directors. and should not impair vested rights. and employees. 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. place.168 Corporate Governance and Finance in East Asia. supervision (regulatory). and between the corporation and the State concerning its franchise or right to exist. A majority of the outstanding shares of shareholders must vote to authorize amendments to the bylaws. To be valid. the bylaws must be consistent with the law. uniform. II to adopt a code of bylaws or rules for its internal governance. In addition. (iii) controversies in the election or appointments of directors and officers of corporations. PD 902-A expanded SEC’s mandate to include absolute jurisdiction. Securities and Exchange Commission: PD 902-A SEC is the government agency responsible for implementation of the Corporation Code. (ii) controversies arising out of intra-corporate relations. However. the corporation’s articles of incorporation. (iii) qualifications. It implements rules and regulations that protect minority shareholders from possible fraud and misbehavior by controlling shareholders. or officers. must be general. and manner of calling and conducting regular or special meetings of the directors and shareholders. and public policy.
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The last item of PD 902-A is the special jurisdiction granted to SEC over applications by corporations for “suspension of payments” to creditors, a role of the regular courts that was originally part of the Insolvency Law. Under this authority to approve applications for suspension of payments, SEC has the power to appoint rehabilitation receivers or management committees for petitioning corporations. A presidential writ issued in 1981 placed SEC under the supervision of the Ministry of Finance, but in 1998, control of the agency was returned to the Office of the President. Insolvency Law The Insolvency Law is designed to effect an equitable distribution of insolvent debtors’ properties among their creditors. It permits debtors to be discharged from their liabilities to enable them to start afresh with property set apart for them from assets to be used as payment to creditors. The regular courts have jurisdiction for insolvency proceedings including suspension of payments for individual debtors. A debtor can petition the court to suspend payment of debts or to be discharged from liabilities and debts by voluntary or involuntary insolvency proceedings. Revised Securities Act: Law on Securities Dealing Like its predecessor, the 45-year-old Securities Act, the RSA was patterned after several US securities acts. The RSA is primarily designed to prevent the exploitation of investors through the sale of unsound or fraudulent securities. For this purpose, the law requires full and accurate disclosure of all material facts concerning the issuer and the securities it proposes to sell, and prohibits misrepresentations, manipulations, and other fraudulent practices in the sale of securities. To enforce these regulations, the law requires the registration of securities. The registration requirement covers full and accurate disclosure of the character of the securities to be sold to the public, including detailed information regarding past dealings between the issuer and its directors, officers, and principal shareholders. Public Listing Rules of the Philippine Stock Exchange PSE is the country’s facility for secondary trading of shares of publicly listed companies. In 1998, SEC, which originally supervised PSE, granted the exchange the status of a “self-regulated” organization. Thus, PSE now
170 Corporate Governance and Finance in East Asia, Vol. II
has the authority, within general guidelines set by SEC, to set rules and regulations for PSE members and listed companies. The general requirements for maintenance of listed status include submission of financial reports that conform with generally accepted accounting principles (GAAP) and regulations established by PSE, and compliance with laws relating to securities and exchange regulations, board resolutions, and agreements executed with the agency. Violations of PSE requirements are subject to sanctions, including delisting. PSE is responsible for ensuring that listed companies follow the exchange’s rules of disclosure and fair treatment of investors. It has the power to impose sanctions on any company that fails or erroneously discloses material information that affects the rights and benefits of investors and misrepresents information in its application, prospectus, financial statements, or reports. In the area of corporate governance, PSE requires corporations to resolve, and, where possible, eliminate arrangements within groups of companies and own-company dealings that can lead to conflicts of interest. Upon complaints by minority investors, PSE can review the deals in question, using such criteria as benefits to the company, adequate disclosure to shareholders, and internal control procedures to ensure fair and reasonable terms. Banking Laws Affecting Corporations Some aspects of banking laws affect the governance of corporations. The important ones concern: (i) the capacity of officers of corporations to assume positions as members of the board of directors of banks, (ii) limits on ownership of banks by nonfinancial corporations, (iii) limits of lending by banks to corporations, and (iv) rules on lending to directors and other insiders. The General Banking Law governs the regulation of the establishment, management, and operations of banks. As the highest policymaking body of the banking system, the Monetary Board prescribes the qualifications of bank directors and reviews the qualifications of those appointed as bank directors and officers. It could disqualify anyone found, for whatever reason, unfit for the position. There are no other restrictions on corporate officers to be appointed as members of the board of directors of banks. A corporation, including its wholly or majority-owned subsidiaries, can own common shares of banks up to a maximum of 30 percent of banks’ voting stock. In the event that the corporation is majority-owned by one person or by relatives, the limit is 20 percent of banks’ voting shares.
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Regulations on the single borrower limit (SBL) put a ceiling on the maximum amount that a bank can lend to a debtor. SBL rules limit the total liabilities of any borrower of a commercial bank to 15 percent of the bank’s unimpaired capital and surplus, and an additional 15 percent for “adequately secured loans,” to a maximum 30 percent (“unimpaired capital and surplus” refers to the total paid-in capital, surplus, and undivided profits, net of valuation reserves of a bank). SBL limits exclude risk-free loans such as Government-guaranteed loans and loans secured by cash deposits. Total corporate liabilities include all liabilities of the debtors and their majorityowned subsidiaries. The Monetary Board may prescribe the consolidation of the liabilities of subsidiaries with the parent corporation under certain conditions. Central Bank (Bangko Sentral ng Pilipinas [BSP]) regulations do not prohibit loans by the bank to its directors, officers, shareholders, and other related interests, known as DOSRI. However, they are subject to certain prudential requirements under banking laws, as follows: (i) a director or officer of a bank can only borrow or become a guarantor, endorser, or surety for loans from the bank with the written approval of all other directors of the bank (i.e., excluding the director concerned); (ii) the amount of outstanding credit accommodations that a bank extends to its shareholders shall be limited to an amount equal to the sum of their unencumbered deposits and book value of their paid-in capital contributions; and (iii) loans and advances given to officers in the form of fringe benefits shall not form part of liabilities under DOSRI.
Corporate Ownership and Control Patterns of Corporate Ownership
The historical development of Philippine corporate ownership is rooted in the country’s colonial past, the industrial policies of the Government, and the recent emergence of industrialists and an entrepreneurial class. During the Spanish and American period up to World War II, a small number of families acquired land and owned large businesses. These families built and preserved their businesses over several generations. Many of them became controlling shareholders of family-based corporations and business groups that are major players in the present-day Philippine corporate sector. Ownership is a key element in corporate control and governance. Public listing rules of PSE require that a minimum of 10 to 20 percent of
172 Corporate Governance and Finance in East Asia, Vol. II
outstanding shares, depending on the size of the company, be available for trading in the stock exchange. As companies usually only issue the minimum required number of shares, large blocs of controlling shareholders often dominate corporate decision making in publicly listed companies. Public investors and minority shareholders are not in a position to influence management. Moreover, the presence of large controlling shareholders makes takeovers by other companies difficult. For these reasons, the resolution of conflicts between the interests of controlling shareholders, minority shareholders, public investors, and creditors in Philippine companies depends very much on the effectiveness of internal control systems. Ownership Concentration of Listed Companies This study measures ownership concentration in terms of shareholdings by the top one, five, and 20 shareholders.5 Table 3.8 shows that the top shareholder owned 40.8 percent of the market value of an average nonfinancial company. The shareholding of the top shareholder varied across sectors. It was highest for the property sector at 54.8 percent, followed by holding companies (as a sector) at 53 percent. One shareholder held majority control of an average company in these two sectors. The average shareholding of the largest shareholder was less than 25 percent only in sectors with large market capitalization, such as power and energy, and transportation, and in sectors with high risks, such as oil exploration and mining. These figures suggest that for publicly listed companies, a single shareholder often has substantial or even dominant control. Combined, the holding of the top five shareholders in an average company was about 65.3 percent for the nonfinancial sector and 59.2 percent for the financial sector. The five largest shareholders held majority control over an average Philippine publicly listed company, except in three sectors—transportation; food, beverage, and tobacco; and oil exploration. Ownership by the five largest shareholders was on average most concentrated among holding companies (78.4 percent), and in construction (74 percent), property (69.8 percent), manufacturing and trading (68.4 percent), and communications (67.3 percent).
The study derived ownership data for 194 (169 nonfinancial) companies out of 221 (190 nonfinancial) listed on the Philippine Stock Exchange as of 1997. Shareholdings by the top one, five, and 20 shareholders were estimated for each company and averaged by using the market capitalization of each company as a weight.
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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
five. In 76 companies. or 80 percent (only nominally publicly listed) of outstanding shares. the top five shareholders owned more than 50 percent of the voting shares. The largest group is nonfinancial corporations. a single owner owned more than 80 percent of outstanding shares. a single shareholder held two-thirds majority control. In 116 companies. or about 30 percent of the total. II analysis of the number of companies in which the top one. or almost 75 percent of the total. Individuals did not constitute a significant shareholder group among the top five shareholders. Table 3. The shares of publicly listed companies are thinly traded and illiquid. the top 20 shareholders collectively owned a majority of a company’s shares. Parent companies usually spin off operating units into new companies that they continue to control as affiliates. 66 percent (signifying strategic control). In 111 companies. a single shareholder held operating control of a company. or 3 percent of the total. 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. including pure holding companies. which are mostly privately owned and controlled by family-based shareholder blocs. There are advantages to establishing pure holding companies. large and family-based shareholders pool the family’s ownership over many . In four of 11 nonfinancial sectors. and share prices are sensitive to movements of foreign funds. or 78 percent of the total. Through these. Composition of Ownership of Publicly Listed Companies Another important issue concerning corporate ownership is the composition of the controlling shareholders.9 shows that in 44 companies.1 percent of publicly listed companies in the Philippines in 1997. or 20 shareholders owned more than 50 percent (signifying operating control). or 51 percent of the total.10. The limited volume of shares issued to the public is one of the causes of the underdevelopment of the Philippine stock market. Who are the top one. five. nonfinancial corporations held majority control.174 Corporate Governance and Finance in East Asia. or 14 percent of the total. Vol. In 21 companies. the top five shareholders held more than two-thirds majority control of a company. and 20 shareholders? In Table 3. In four companies. controlling an average of 52. With such high levels of ownership concentration. the top five controlling shareholders were classified into eight groups.2 percent of outstanding shares of publicly listed companies. holding only an average of 2. Nonfinancial corporations with controlling shareholdings are likely to be holding companies.
10 manufacturing companies. Distribution.9 Ownership Concentration at Critical Levels of Control Over Publicly Listed Companies. Source: PSE databank.Table 3. Beverage. a Data for top 20 shareholders were not available for five holding companies. 1997 % of Firms with Top Shareholders Controlling more than 50% of Shares Top 1 30 40 50 20 31 — 14 24 30 90 80 86 72 73 50 57 72 74 100 87 93 36 82 100 100 80 78 20 13 43 8 14 — — 8 14 70 60 57 48 49 50 14 52 51 Top 5 Top 20a Top 1 Top 5 Top 20a 90 80 86 36 76 100 71 76 72 % of Firms with Top Shareholders Controlling more than 66% of Shares % of Firms with Top Shareholders Controlling more than 80% of Shares Top 1 — 13 7 — 2 — — — 3 Top 5 40 33 50 28 27 50 — 28 30 Top 20a 60 67 64 20 47 50 43 36 45 Sector Communication Construction Food. and two companies in the property sector. . and Tobacco Manufacturing. and Trading Holding Power Transportation Property Total — = not available.
8 0. and Tobacco Holding Companies Manufacturing.0 0.1 0.0 5.2 59.0 0.9 0.0 0.2 0.7 67.0 4.3 12.0 1.7 0.0 0.0 0.3 0.1 a Weighted by market capitalization.0 2.0 0.5 12.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.6 33.4 29.8 0.0 5.7 0.7 1.4 2.4 8.0 1.1 5.6 1.0 0.6 18.Table 3.0 45.0 2.2 3.0 0.3 5.7 0.5 0.9 0. Source: PSE Databank.4 1.0 0.5 13.2 3.6 0.0 0.2 0.3 0.9 52.1 1.2 0.0 0.5 4.6 0.3 0.2 10.0 0.6 0.0 10.0 1.6 0.1 8. and Trading Hotel.3 26.4 19.5 0.7 0.5 4.8 21.0 1.8 11.3 0.5 26.0 7.6 2.1 6.0 1.0 5.0 5.7 3. Recreation.1 0.5 53.0 1.2 3.7 0.0 1.3 1.4 0.0 0. 1997 (percent) Nonfinancial Investment Nominee Commercial Company Trust Fund Company Individual Bank Government Securities Broker Insurance Company Sector Financial Company Banks Financial Services Average Shareholdinga Nonfinancial Company Communication Power and Energy Transportation Services Construction and Other Related Products Food.9 6.1 7. Distribution.6 0.3 0.1 9.4 5.2 0.2 5. and Other Services Property Mining Oil Average Shareholdinga 33.6 0.0 0.0 1.7 0.3 1.8 66.6 2.6 12.3 37. Beverage.8 0.6 0.6 9.0 0.2 1.2 0.5 2.3 5.9 36.6 5.7 3. .2 3.3 2.
. securities brokers (1. Because of limited ownership by institutional investors.2 percent in 1997. They can also better manage their income taxes because income from affiliated companies passes through a holding company.Chapter 3: Philippines 177 companies and share in the risks and profits of the group. Such advantages have contributed to the popularity of holding companies among publicly listed companies.7 percent of market capitalization of the nonfinancial publicly listed companies. financial institutions did not have a significant ownership in nonfinancial corporations. accounting for P258. 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.6 percent of market capitalization in 1997.6 billion or 26. Petron and MERALCO in power and energy. The financial institutions among the top five shareholders of nonfinancial corporations are investment trust funds (with 4. and insurance companies (0. with an average of only 7. Holding companies were themselves 66 percent owned by other nonfinancial corporations.1 percent).3 percent). and San Miguel Corporation (SMC) in food and beverages. These are mainly the Social Security System (SSS) and the Government Service Insurance System (GSIS). These include Philippine Long Distance Telephone Company (PLDT) in telecommunications.7 percent of shareholdings).5 to 12. The investment funds’ presence in these sectors ranged from 8. respectively. while still allowing the public to own minority shares. Holding companies as a sector had the largest market capitalization in PSE in 1997. As a group. Privately-owned pure holding companies own a majority of shares and exercise control of publicly listed holding and operating companies through a multilayered pyramid structure.2 percent 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. This complex layering of ownership masks the identity of individuals or families that actually own and control operating companies. The Philippine capital market did not have an active analyst community comparable to those in more developed capital markets. Investment trust funds were the most important institutional investors. commercial banks (1. 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.1 percent). These institutions keep a stock portfolio mostly in shares of a few companies with large capitalization and high liquidity in select industries. The 7.
000 Corporations in the Philippines. A common feature of corporate ownership of a business group is the centrality of a commercial bank.4 percent of the top 1.178 Corporate Governance and Finance in East Asia.000 companies. Foreign banks have a growing presence but have not necessarily increased the supply of credit to the corporate sector. including SBL and DOSRI rules. II Family-Based Ownership and Business Groups The Asian Development Bank (ADB) survey of publicly listed companies conducted for this study reveals that about one third of responding companies started out as family businesses. To understand the ownership and governance characteristics of family-owned business groups. and tracked the financial performance of each company from 1992 to 1997.11). including 16 commercial banks. suggesting that business groups are common in all major markets. using data on the Philippines’ top 1. Banks that are members of business groups have an advantage in raising funds from the internal capital market of the group. Commercial banks hold the largest share. Prudential regulations. identified the companies belonging to each of these groups. but they comprised only 23. Vol. For this reason.000 corporations’ sales. Family-based groups have larger companies since their total sales were about 33. This is significant considering that there were only 31 local commercial banks in the country in 1997. Corporate financing depends on intermediation by banks. All major industries were represented. Still. Some 20 financial institutions were affiliated with these groups. so far limiting their involvement to selected products. remain in force to control excessive lending of banks to insiders. many companies in family-owned groups are not publicly listed.8 percent of total companies in number. Large shareholders and their families own these banks directly or through their controlled companies. the Central Bank’s reforms are probably changing the conduct but not necessarily the structure of the banking system. about three fourths. .6 The total sales of these groups in 1997 were estimated at P806 billion (Table 3. The Central Bank deregulated interest rates and foreign exchange. liberalized the regulations on entry of foreign bank branches and foreign ownership of local banks. a nonfinancial company that owns a commercial bank has better access to loans at favorable rates and terms. the study put together a list of prominent business groups. and increased the capital requirements for all types of banks. suggesting that most publicly listed companies are parts of business groups.7 6 7 The study used publicly available shareholder information and published reports. More than three fourths of the respondents are either a parent or subsidiary (about 70 percent of these are domestic nonfinancial companies). However. 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. This could further increase the concentration of ownership and expand the scope of own-group lending by these larger banks. The process identified a total of 238 companies belonging to 39 business groups from the SEC-BusinessWorld Annual Survey of the Top 1. of the financial resources in the country.
the three largest entities were family-based groups. it was manufacturing (36. with the exception of Banco de Oro. with 27 affiliated companies in the top 1. In terms of number of companies. as discussed in previous sections. the two were closely related through their affiliations to business groups. the top 10 family-based business groups had only 119 companies in the top 1. To show this. Lopez. Foreign-owned companies mainly serve the export markets. or an average of about 12 per group. In the meantime. Gokongwei. the biggest private company in the Philippines. the study used the four largest business groups—Ayala. the largest was the Eduardo Cojuangco group.4 percent of the group’s 1997 profits).8 percent). Together. These corporate entities accounted for 53. and more than 20 percent for the Lopez group and Henry Sy group. the nonfinancial sector was real estate (60.000. The main constraint may be the availability of family members that could be drawn for top management positions. Commercial banking contributed about 40 percent of group profits for the Ayala group and Gokongwei group. nonfinancial companies contributed about 36 to 60 percent of total profits for these groups. in most . for the Lopez group. a substantial proportion of group profits came from its financial subsidiaries. Lopez. the principal owner of SMC. Also.000 companies. In terms of sales. and Henry Sy—as examples.2 percent). real estate. including business groups and independent companies.1 percent). It is also noteworthy that. which was majority-owned by the Henry Sy group.6 percent of the total sales of the top 1. for each of these groups. construction. Commercial banks are often affiliated to a particular business group. Significantly. For the Ayala group. and for the Henry Sy group. ranged according to their sales (Table 3. Family-based business groups are most dominant in sectors such as manufacturing. the largest family-based business group was the Ayala Corporation Group. Cojuangco.000 corporations in 1997. 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. broadcasting (49. 25 out of the 50 top corporate entities were familybased groups. The significance of family-based business groups in the Philippine corporate sector is immediately evident in the 50 largest corporate entities.Chapter 3: Philippines 179 Compared with other Asian countries. namely.12). for the Gokongwei Group. an average group in the Philippines has fewer member companies. and banking. retail merchandising (69. In 1997. and Ayala.
9 2. 15.3 11. 4. coconut oil.11 Total and Per Company Sales. agriculture.6 7.2 16.9 3. and tourism Credit card 18.5 6.0 17. and personal care prods Shipping.2 1.5 47. 1997 Business Group 19 15 27 12 12 9 4 6 11 4 8 9 5 4 5 6 Major Sector Orientation Estimated No. 17. 13. 3. Sector Orientation. 14. and Affiliated Bank of Selected Business Groups.4 . real estate. 11. 16.4 10. food. and car manufacturing Car manufacturing and real estate Food and telecommunications Department store and real estate Airlines. and packaging Power distribution and mass communications Real estate. power.6 3.1 4.5 49. food. and tobacco Telecommunications Cement and construction materials Pharmaceutical and distribution 12.0 Average Sales Per Company (P billion) 6. Flagship Company.5 17.0 5. telecom.1 4.0 13. Real estate. 10.4 6.Table 3. 8. construction. 9. and food Food.3 2.2 1.1 2.3 3.5 13. beverages.3 15. and mining Management.6 2.5 44. beverages. and dairy products Investments.0 26. 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.5 46.5 26. 6. 5.7 98. Beverages. of Affiliated Companies Total Sales (P billion) 123.6 3. 2.8 84. Consunji 4 3 Food and dairy products Construction and mining 10.4 48. 7. Eduardo Cojuangco Lopez Family Group Ayala Corp.5 2.
1 1. 21.7 0.1 1. 4 238 1. 31. SEC-BusinessWorld Annual Survey of Top 1.2 4. 26. distribution.19.9 6.2 1. Ramos Gaisano Family Group Felipe Yap Felipe F.9 0. 39.8 6. 32.6 5.4 5.7 0.4 1. 23. 28. 37.9 0.9 7.8 1. and real estate Retail merchandising Ceramics and real estate Department store and real estate Cement and sugar central Real estate and securities trading Bookstore.8 1. 29.6 Fast food Beverages and agro-industrial products distribution Cement and wood products Retail merchandising Electronic appliances Real estate Mining Real estate Telecommunication.5 2. .0 5.1 2.3 7. 25. 30. 36. 24. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/ Fil-Estate Group Total Real estate Sources: PSE Databank.000 Corporations (1997). 34.6 2. 22.0 2.3 2.7 4. 27.7 0.8 Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J.6 3.0 1. and various company annual reports.6 0.1 0.9 1.7 3.3 2.4 3.1 805. P.9 1.2 6.4 3. 35. 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. 33.9 1. 38.5 8. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. 20. mining.7 1.8 1.0 0.
11 (continuation) Total and Per Company Sales. 12. 5. 14. 2. Jollibee Foods Corporation Pepsi Cola Products Alsons Cement . 11. 19. 17. 8. Sector Orientation. 7. 21. 4. 15. 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.Table 3. 13. 6. 20. Flagship Company. 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. 1. Alaska Milk Corporation DM Consunji. Inc. 16. 9. 3. Long Distance Telephone Phinma Zuellig Pharmaceutical Metro Pacific William Gothong and Aboitiz Swift Foods/RFM House of Investment Anscor Equitable Card Network Inc. 10. 18. and Affiliated Bank of Selected Business Groups. Eduardo Cojuangco Lopez Family Group Ayala Corp. Uytengsu/General Milling Group David M. 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.
Inc. Keppel-Monte Bank Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. 32. Fil-Estate Development Inc. 34. 38. 31.000 Corporations (1997). 22. 29. unless otherwise indicated.48 billion. Cruz & Co. 23. 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.. 33.65 billion to P4. 35. Sources: PSE Databank. small = less than P1.48 billion. 26. 25. 27. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. Ramos Gaisano Family Group Felipe Yap Felipe F. medium = P1. . P. Refers to commercial banks. 28. SEC-BusinessWorld Annual Survey of Top 1. 30. and various company annual reports. 36. 37.East-West Bank International Exchange Bank Ecology Bank (Savings Bank) Dao Heng Bank Orient Bank International Exchange Bank International Exchange Bank Philbanking Corp. F. Kepphil Shipyard Inc.65 billion. 24. a b Size class is measured in terms of sales: Large = greater than P4. PT&T Corp. 39.
8. Petron Corporation Pilipinas Shell Petroleum Corporation George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Caltex (Philippines) Inc.5 26. Texas Instruments (Phils.8 53. bank. food. and real estate Banking.6 26. 4.6 18. 14.2 Business Group Business Group Business Group Government. and personal care products Shipping.5 77. food. 17. and car manufacturing Power Refined petroleum products Refined petroleum products Banking. 19.0 38. 10. Inc.and Foreign Jointly Owned Business Group Business Group Business Group Government-Owned Publicly Listed/Foreign-Owned Foreign-owned Business Group Business Group Business Group Business Group Business Group Foreign-Owned Foreign-Owned Business Group Business Group Foreign-Owned Privately-Owned Publicly Listed/Foreign-Owned Privately-Owned Business Group Corporate Entity 1.4 19. 2. car manufacturing. 7.5 17. food.0 24. 9. First Pacific/Metro Pacific Group 21. power.2 49. 5. Beverages. 1997 Sales (P billion) Control Structure Major Industrial Orientation 123. banking. 16. and mining Gold and other precious metal refining . 13.5 47. mass communications. and food Food.8 84. 11.3 15. and packaging Power distribution. and tobacco Telecommunications and banking Refined petroleum products Radar equipment and radio remote control apparatus Cement and construction materials Pharmaceutical and distribution Electronic data processing equipment and accessories Electronic data processing equipment and accessories Bank Drugs and pharmaceuticals goods retailing Real estate.12 Control Structure of the Top 50 Corporate Entities. 3.5 15. and dairy products Investments. 23.2 16. 6.1 60. 22. beverages. Eduardo Cojuangco Lopez Family Group Ayala Corporation Group National Power Corp. Philippine National Bank Mercury Drug Corp. Fujitsu Computer Products Corp.1 17. 20.). agriculture. of the Phils. telecommunication.). beverages.0 37. Inc. and bank Real estate.8 22. Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Philippine Associated Smelting and Refining Corp. Del Rosario/PHINMA Zuellig Group Toshiba Information Equipment (Phils.5 44. 15.4 48. 12.5 46.Table 3. and telecommunications Department store and banking Airlines.7 98. construction. 24. 18. coconut oil.
9. and various company annual reports. . 40. 50. 42.7 10.9 7.4 10. Inc.5 10. 34. 47. Corp.0 12. including biological products Bank Cement and wood products Retail merchandising Electronic appliances Mining Real estate Sources: SEC-BusinessWorld Annual Survey of Top 1. 35. PSE Databank.7 10.8 6.A. 29. Inc.290 53.7 13. and other grains wholesaling Other amusement and recreational activities Motor vehicles Food and dairy products Construction and mining Television and radio transmitters. National Steel Corporation National Food Authority Phil.3 13.5 8. EAC Distributors Inc. 45. Philip Morris Philippines.000 Corporations (1997). 46. W.5 8.1 9. 33. 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. 30.9 14.8 9. 44.0 11. radio and remote control apparatus Fast food Bank Beverages and distribution of agro-industrial products Drugs and medicines. Philips Semiconductors Phils.25. corn (unmilled). 37. 14. real estate. 43.6 9.3 8.2 7. Amusement and Gaming Corporation Mitsubishi Motors Phils. Jollibee Foods Citibank N.6 1.6 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.000 Companies Sales (%) Cigarettes Bank Soap and detergents Management.4 8. 28.9 7.0 5. and tourism Banking Radar equipment and radio remote control apparatus Operation of rolling mills Palay..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 38.0 13. 41. 49. 32. Consunji Uniden Philippines Laguna. 39. 48. 36. 31.9 6. Inc. 27. and apparatus for line telephony and line telegraphy Tobacco products wholesaling Cigarettes Radar equipment. 26. Uytengsu/General Milling Group David M.6 12.
amendments in the bylaws. sale or disposition of a substantial portion of corporate assets. to the corporation and its shareholders for damages caused if they agree to unlawful corporate acts. Of course. jointly and individually.2 Corporate Management and Shareholder Control The main mechanisms by which shareholders control corporate management are the board of directors. issuance of stocks. This section reviews practices of corporate management and shareholder control in Philippine publicly listed companies. The Corporation Code holds members of the board of directors liable. II publicly listed commercial banks affiliated to these groups. Vol. approval of management contracts. 3.3. A total of 44 companies responded to the survey (out of about 221 financial and nonfinancial listed companies). removal of directors. shareholder voting in general meetings and legal protection of their rights. determination of compensation to board members. accounting and auditing. and declaration of cash dividends. corporate mergers or consolidations. the board of directors plays a crucial role in corporate governance. appointment and compensation of senior executives. such as amendments of the articles of incorporation. The Philippine Corporation Code mandates the board of directors to exercise its control over a corporation. The review is based on an ADB survey of listed companies in the Philippines conducted in 1999 for this study. However. They are likewise liable if they pursue financial interests that conflict with their duty as directors. 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. investments of corporate funds in other companies or purposes.8 The Board of Directors As the representative of shareholders in a company. although public investors held a majority of shares. . Shareholders limit the broad power of the board by ratifying their decisions on critical corporate affairs.186 Corporate Governance and Finance in East Asia. these were dispersed shareholdings. business groups had only minority ownership. and financial disclosure. issuance of corporate bonds. voluntary dissolution. Actual control of the banks was still held by the groups.
In practice. or the Government without approval by shareholder general meetings.9 percent). in a descending order. Making day-to-day management decisions was not regarded as an important board responsibility. and determining remuneration for board directors and senior management. 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. Respondents of the ADB survey ranked the following as the most important responsibilities of the board: making strategic decisions. But half of respondents indicated that they also had board directors directly nominated by controlling shareholders or management. But professional expertise is also an important criterion (28. The longest was 27 years for board chairpersons and 14 years for board directors. Board chairpersons in a substantial number of responding companies did not own significant amounts of shares in their personal capacities. The ADB survey shows that the number of board directors ranged from six to nine among the responding companies. The majority of respondents indicated that board directors and chairpersons were elected mainly on the basis of either relationship with major shareholders (31. appointing senior management.7 percent).6 for board chairpersons and 7.Chapter 3: Philippines 187 actual practices of board functions and the role of shareholders may diverge somewhat from the legal framework. or percentages of shareholdings (28. appointed by the Government. The ADB survey results show that a chairperson is compensated either by a fixed fee (52 percent of respondents). ensuring that a company follows legal and regulatory requirements. Such a short tenure may to some extent suggest that large shareholders want to keep their board members under close control.7 percent). or a per diem for meetings (18 percent).5 for board members. with a maximum of 36 percent. protecting shareholder interests. More than half of respondents indicated that board directors were elected during the shareholder general meetings. Financial compensation is another means by which shareholders can motivate boards and board members to manage companies in their interests. In a few cases. The average stipulated term of office of the chairperson and members of the board for most responding companies was one year. or representatives of creditors. board directors were the founder of a company. a fixed fee plus performance-related bonuses (30 percent). This can partly be explained by the fact that many family-based large shareholders control companies through holding companies in which they have majority ownership. According to the ADB survey. .
large shareholder-dominated companies often view such committees as unnecessary formalities. Ninetythree percent of the respondents had one or more outside directors. however. relationship with controlling shareholders (35 percent). only 35 percent of responding companies have set up board committees. the parent company or company bylaws (21 percent). or management (15 percent). The compensation committee reviews and recommends remuneration plans of key officers and employee stock option plans. The audit committee selects external auditors. About half of the active committees were audit committees and the other half nomination committees. The nomination committee searches and reviews candidates for key management positions. But the independence of these outside directors is often doubtful.9 In practice. by tenure and compensation.188 Corporate Governance and Finance in East Asia. the CEO 9 The three most common board subcommittees are the compensation. Vol. In some companies. CEOs apparently cannot increase their shareholdings because family-based owners restrict the number of shares available to management. Companies may set up special board committees to strengthen due diligence procedures. Unlike in Western corporate models. and nomination committees. or amount of shareholding (15 percent). namely. and reviews the findings of external audits. audit. It is also not clear whether the outside directors were elected before or after the financial crisis. . These committees were established only recently. There was no case found in the ADB survey where a minority shareholder invoked such a provision of the Corporation Code. The ADB survey shows that in 41 percent of the responding companies. Senior Executives The Corporation Code does not specify the role and responsibilities of senior executives. When the CEO was not the chairperson. negotiates the audit fees and scope of audits. owners brought prominent political or civic leaders into their boards with the intention of improving the visibility of the corporation rather than improving the quality of board decisions. A CEO that was not the chairperson of the board was selected on the basis of professional expertise (42 percent of respondents). This suggests that large shareholders control CEOs by means other than shareholdings. II Compensation for the chairperson was determined either by the board (54 percent of respondents). The Corporation Code prohibits the removal of any director without cause if that act would deprive minority shareholders of representation in the board. the chairperson of the board was also the chief executive officer (CEO). In the ADB survey.
or (iv) enters into a merger or consolidation with another corporate entity. to help ensure the representation of minority interests in the board. Fifth.. first. and (iii) involvement of directors in businesses that compete with the company. the Corporation Code requires that the following types of transactions involving potential conflict of interest between shareholders and management be reviewed and approved by the board: (i) dealings of a company with directors or officers. The majority of responding companies compensated their CEOs by using a fixed salary plus a performance-related bonus. if the CEO’s contract was preterminated. About 60 percent of respondents of the ADB survey considered maximizing shareholder values as the CEO’s most important responsibility. Shareholder Rights and Protection Under the Corporation Code. including electronic means. Among others. . Third. Only one respondent indicated that its CEO was entitled to a substantial amount of compensation. shareholders have preemptive rights to maintain their proportionate ownership of a company under any financing plan that may be undertaken by the company. the Corporation Code allows cumulative voting for directors. Second.2 years. shareholders enjoy a number of rights and protection. 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. (iii) invests in another company for a purpose different from that of the corporation. But about 27 percent viewed it to be ensuring steady growth of the company. without cause. They can vote through proxy. shareholders may exercise appraisal rights. A substantial number of respondents also considered looking after interests of other stakeholders and the general public as among the important responsibilities of the CEO.Chapter 3: Philippines 189 was not related to the chairperson by blood or marriage in all of the cases except one. The average service length of CEOs was 5. i. The longest service rendered was 27 years.e. and prohibits the removal. 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) disposes of or mortgages a substantial portion or all of corporate properties and assets. of directors representing minority shareholders. The “golden parachute” was apparently not a common feature of CEOs’ compensation packages. Companies are not allowed to issue shares with different voting rights. equal to three years’ pay. Fourth. (ii) contracts with companies linked through interlocking directorship.
because of the dominance of large controlling shareholders. board members are likely to be under pressure to approve transactions that benefit controlling shareholders to the detriment of minority shareholders. An effective market for corporate control may provide some protection for minority shareholders against the expropriation of their interests by the incumbent management. there were often no real discussions of board proposals or actions.190 Corporate Governance and Finance in East Asia. Dissenting minority shareholders did not necessarily have recourse to a third party for an objective appraisal of their shares. During annual general meetings where minority shareholders could exercise their rights. Those who did were usually offered below-market values for their shares. that of Interport Resources Corporation. minority shareholders were often vulnerable to the expropriation of their interests by controlling shareholders and management. In practice. SEC proceedings were costly and time-consuming. 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. no one has been successfully prosecuted for insider trading. because of poor compliance and enforcement as well as some loopholes in corporate laws. there are no requirements for disclosing such transactions to shareholders under the Corporation Code. Vol. Sixth. There was little chance that a proposal from minority shareholders could ever get approved. In the case of preemptive rights. But an action by the regular court on a petition by the company’s owners/officers prevented SEC from pursuing the investigation. However. it is doubtful whether this legal protection for shareholders will achieve what it intends to in practice. Last. a shareholder could file a derivative suit against a director to redress a wrongdoing. II shareholders are allowed to inspect a company’s stock and transfer books. Few minority shareholders actually exercised their appraisal rights. where SEC made substantial progress in investigation. In the past. In cases of derivative suits against directors for wrongdoings or actions against insider trading. Being appointees of controlling shareholders. the Corporation Code allows a company to waive this in the article of incorporation upon registration or in a subsequent amendment. Consequently. in cases of corporate takeovers. The company was dissolved before indictment. Although transactions involving potential conflict of interest need to be reviewed and approved by the board. hostile takeovers are not common because in most companies ownership is concentrated . Regardless of the amount of shares held. There was only one case. in the Philippines. the Revised Securities Act has strict provisions designed to deter insider trading.
6 Independence of Auditing The ADB survey revealed that all the responding companies had an independent auditor.8 92.4 No 0.900 shareholders per company did not vote during the last annual general meeting.Chapter 3: Philippines 191 in a few controlling shareholders and families. Nominees held about 45 percent of the outstanding shares. Table 3.0 51. protection.2 69.8 56. About 93 percent of the respondents contracted .0 63. and their activism in the corporate sector.0 48. representing about 24 percent of outstanding shares.2 7.0 36. the successful hostile takeover by First Pacific Group of PLDT.6 30. appointed either by the board or shareholders during the annual general meetings.4 percent of shareholders but 58 percent of outstanding shares.3 56.8 30.7 43. The responding companies had on average 43. The ADB survey provides further evidence on shareholder rights. Table 3. About 333 shareholders per company voted by proxy.13 summarizes rights that the shareholders of the responding companies enjoyed. a company that is widely held but has a large shareholder.522 shareholders each. The brokers or securities companies were the most important proxy voters.4 70. Nevertheless. Yes 100. An average of about 4.2 43. 1999. demonstrates the feasibility of developing a market for corporate control if publicly listed companies were widely held. An average of 327 shareholders per company attended the last annual meeting and they represented about 63 percent of total shares. followed by management and banks.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. representing 3.
Most major international auditing firms operate in the Philippines. In practice. Nevertheless. a hostile takeover case). revaluation of fixed assets. or the accounting standard of a specific developed country (for example. and an analysis of financial statements. More than 20 percent of the respondents have been dealing with their auditors for 20 years or more. independent audits do not guarantee the absence of questionable accounting practices. Vol. Because of such long relationships. there are many cases of poor financial reporting by large companies. In two celebrated cases. The accounting profession in the Philippines is considered fairly developed and Manila is a known regional center for accounting expertise. the responding companies have been associated with their present auditors for 13 years. . An auditor can choose among three alternative sets of GAAP. intangible assets. financial reporting standards allow room for interpretation by independent auditors.. On average. long-term leases. 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. foreign currency-denominated liabilities. Meanwhile.e. the US GAAP). These different versions of GAAP. the agency also requires reports on important details about their operations and management. although closely related. vary in their evaluation of some major accounts such as securities and other liquid assets. a preferred independent auditing firm either reported assets that did not exist (Victorias Milling Corp. the local standard (i. intra-company receivables and payables. a management discussion of the business.192 Corporate Governance and Finance in East Asia. the information statement transmitted to every shareholder should contain the audited financial statements. The Code grants a shareholder the right to inspect business records and minutes of board meetings. investments in subsidiaries. and consolidation policy. with the longest being 50 years. imposing penalties on violators. the international accounting standard. Nevertheless. namely.. SEC requires all registered companies to periodically submit reports for the purpose of updating their respective registration statements filed at the agency. II their annual audit to an international auditing firm. a bankruptcy case) or hid a large amount of liabilities and losses (PLDT. as practiced in the Philippines). independent auditors are likely to be quite familiar with the operations and financial aspects of their clients. From publicly listed companies.
as large shareholders had no need for financial statements to monitor their companies and management that were under their own control. controlling shareholders in the Philippines usually exercise their corporate control through the setting up of business groups. namely SEC and the Philippine Institute of Certified Public Accountants (PICPA). Family-based controlling shareholders use them as vehicles for controlling business groups. 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). which are controlled by large shareholders with public investors in a minority position. e. Even for widely held public companies. Such expropriation is due to gaps between control rights and cash flow rights that pyramiding structures of business groups centered on holding companies create. Corporate Control by Controlling Shareholders As in many other Asian countries. sometimes did not penalize independent auditors for poorly prepared audited financial statements. They allow risk pooling and can achieve economies of scale in management. Publicly available financial information was often of low quality. they formed the largest group of corporate entities in the Philippine stock market in 1997. “Selective public listing” is a strategy of many business groups for channeling funds from public investors to member companies. marketing. However.Chapter 3: Philippines 193 Many small.and medium-sized businesses did not have quality financial statements. When control rights exceed cash flow rights. and publicly listed.g. which are closely held by large shareholders and family members. and financing.6 billion. they also make it easier for controlling shareholders to expropriate interests of minority shareholders. The popularity of holding companies in the Philippine corporate sector is evident: with a market capitalization of P258. 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. accounting for 27 percent of the total stock market capitalization that year. from a minority-controlled to a majority-owned subsidiary. arguably.. Controlling shareholders usually select member companies that require large . the authorities. Pure holding companies can be privately owned. because of the highly concentrated ownership of Philippine corporations. Holding companies enable controlling shareholders to collectively own shares of other companies in a business group and to centralize the group’s management.
and a passive minority investment at 15 percent in Honda Cars (Philippines). controlling shareholders of a parent company hold these shares as “strategic investments” that they could increase or reduce depending on business opportunities. Controlling shareholders gain additional leverage in management control over minority-owed companies. and customers. is privately owned. active minority or passive minority holdings.1 percent of Ayala Land. Public investors collectively hold a minority of 41 percent. as an example (Figure 3. They may have a representative in the board. Vol. Minority-owned companies may also need access to resources of the group. In an active minority-owned operating company. The stylized features of control structure of business groups in the Philippines can be illustrated by using a leading Philippine family-based conglomerate. Selective public listing combined with use of pure holding companies to own and control member companies lead to various organizational structures of business groups. of Cebu Holdings (a publicly listed government-owned company). a family-owned pure holding company. an active minority share at 44.4 percent of Bank of the Philippine Islands.and minority-controlled operating companies are also holding companies. financing. Ayala Land fully owns Makati Development Corporation and holds a minority stake. with 59 percent of shares. . the parent company plays an active role in management.1). The first three companies are publicly listed while the fourth. Ayala Corporation’s majority. especially its management. Depending on the performance of the company. These investments can be classified according to the role of the controlling shareholders in the management of the invested company. minority control at 42. They are operating companies but at the same time have majority or minority share ownership in other operating companies.. at 47. Honda Cars (Philippines). controlling shareholders of the parent company may eventually increase their shares to a majority position. II equity investment for public listing.194 Corporate Governance and Finance in East Asia. In a passive minority-owned operating company. Inc.6 percent of Globe Telecom. namely. controlling shareholders of the parent company do not participate in management. In cases of minority ownership. 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. Some holding companies are not pure holding companies. Ayala Corporation is a publicly listed pure holding company. It has a majority control at 71. It is majority-owned by Mermac.2 percent. This is most evident when a minority-owned company transacts with other members of the group where the controlling shareholders hold majority control. Ayala Corporation.
04%) <50% Ayala Corporation >50% Publicly Listed Pure Holding Company >50% MajorityControlled Operating and Holding Company Ayala Land (71. (47. . Inc.06%) <50% >15% &<50% Active MinorityOwned Pure Operating Company Globe Telecoms (44. (58. (15%) MinorityControlled Operating and Holding Company Bank of the Philippine Islands (42.1 Corporate Control Structure: The Case of Ayala Corporation Family Members 100% Mermac.Figure 3. Inc.96%) Privately-Held Pure Holding Company Public Investors (41.2%) >50% MajorityControlled Pure Operating Company BPI Family Savings Bank (100%) <50% MinorityControlled Pure Operating Company Note: Data as of 31 December 1998.6%) <15% Passive MinorityOwned Pure Operating Company Honda Cars Phils.44%) >50% MajorityControlled Pure Operating Company Makati Development Corporation (100%) <50% MinorityControlled Pure Operating Company Cebu Holdings.. Inc.
64% +37.5% x 14. Simeon Djankov. see the World Bank research papers by Stijn Claessens. Expropriation of Minority Shareholders: Evidence from East Asia. 1998.5%] [39. The Separation of Ownership and Control in East Asian Corporations. P.44%] = [42. Lang. Who Owns and Controls East Asian Corporations? 11 Ibid.196 Corporate Governance and Finance in East Asia. 1999b.2).8%] 5. Vol.5%] / [(88. they exercise far greater control (two to five times more) than they are entitled to by virtue of their ownership rights. is illustrated in the Lopez Group (Figure 3.11 The Lopez family’s control rights over MERALCO was 5. however. II Bank of the Philippine Islands owns 100 percent of the BPI-Family Savings Bank. [control right] [control rights via Ayala Corporation] = [cash flow right] [cash flow rights via Ayala Corporation] = [42. and First Philippine Industrial Corporation are indirectly held by a majoritycontrolled holding company.7 times its cash flow rights by virtue of the double layer pyramid structure of the Ayala group. and Larry H.12 These examples show that even when large shareholder groups are minority shareholders. defined as control by large shareholders of an operating company through minority ownership by several companies. Benpres Holdings.10 The Ayala family’s control rights over BPI was 1.64%) + (37. indirect shareholdings do not appear to be a prevalent practice in the Philippine corporate sector. [control right] [cash flow right] = = = = = [sum of control rights via Benpres and First Holdings] [sum of cash flow rights via Benpres and First Holdings] [1.44%] / [58. a privately owned company. The situation offers large shareholders tremendous incentive to move resources 10 For details. Lang: 1999a. Diversification and Efficiency of Investment by East Asian Corporations. Generally. The control of companies through indirect corporate shareholdings.14%] / [6. and a minority-controlled holding company. Simeon Djankov. H. and Larry H. MERALCO. First Philippine Holdings Corporation.76%)] [39.3% x 5.98% x 42. companies in the Lopez Group are large and minority-controlled. and 1999c.7 times Ibid.7 times its cash flow rights by virtue of its cross-holdings via Benpres and First Holdings.44%] / [25%] = 1.7 times 12 . Fan.3% x 1. Rockwell Land. Being in the public utilities sector. Joseph P.14%] / [1. The Lopez Family owns a significant portion of shares of these companies if these indirect shareholdings are summed up and attributed to the beneficial owners. P. See also Stijn Claessens.
3% 11.76% Operating Company MinorityControlled 24.64% MinorityControlled 14.7% 62. .Figure 3. Inc.5% Operating Company MajorityControlled Operating Company Rockwell Land Corporation 24. Privately-Held Pure Holding Company 88.2 Corporate Control Structure: The Case of Lopez Group Public Investors Family Members Lopez.5% Minority-Controlled Publicly Listed Pure Holding Company First Philippine Holdings Corporation Benpres Holding Corporation Majority-Controlled Publicly Listed Pure Holding Company Manila Electric Company 1.5% First Philippine Industrial Corporation 50% 50% Note: Data as of 31 December 1998.
Most responding companies had dealt with their commercial bank creditors for more than five years and nonbank creditors for only about two years. 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. 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. 3. the data suggest. Most respondents (81 percent) indicated that they had renegotiated with their creditors on loan repayment when they faced liquidity problems. and (ii) how the legal framework protects creditor interests and rights.198 Corporate Governance and Finance in East Asia.3. a publicly listed company dealt with an average of eight banks and six nonbank financial institutions. Control by Creditors According to the ADB survey. The average company.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. Suspension of Payments of Debts Under PD 902-A. Vol. whether for working capital or capital expenditure. The controlling shareholders could also use the resources of minority-owned subsidiaries to engage in overexpansion and empire building investments. II from their subsidiaries to their majority-owned publicly listed holding company or elsewhere up the pyramid. Some 85 percent of respondents believed that creditors had no influence or only weak influence on corporate management. Only a minority of respondents (18 percent) indicated that they had faced adverse creditor actions such as a collection lawsuit or foreclosure of collateral. SEC could suspend the rights of a creditor to demand payment from a borrower in accordance with the terms of the loan . while 80 percent reported that creditors with which they had renegotiated loans were still willing to lend to them. However. Sixty-one percent of respondents indicated that creditors usually asked for collateral for all types of loans.
a real estate-based business group. including the rehabilitation of the corporation. SEC could intervene to avoid asset dissipation. Publicly listed companies do not represent a cross section of the Philippine corporate . 3. 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. SEC and the court required that the creditors of BF Homes. In practice. The borrower will propose a rehabilitation plan to SEC. Inc. Consequently. Markets for equity and debt instruments are small and there are serious structural problems that discourage large. a company’s assets are of sufficient value to cover all of its debts.Chapter 3: Philippines 199 agreement. The corporation continued to be under rehabilitation receivership as of June 1999. wait for 14 years from the time the company petitioned for suspension of payments in 1984. Under such circumstances.1 Corporate Financing The Financial Market and Instruments The Philippine financial market has remained underdeveloped compared with other countries in the region. There are no legal or practical limits to the time period of suspension of payments. under which. Under this mode. The second mode is for suspension of payments with the appointment of a management committee (Mancom) or rehabilitation receiver. There are two modes of suspension of payments under PD 902A. PD 902-A granted SEC blanket powers to intervene and adjudicate claims. For example. 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. This explains why creditors invariably oppose any move by borrowers to file for suspension of payments at SEC..4. An impending conflict between the two parties could result in dissipation of assets of the company due to creditors’ action to liquidate the company’s assets they hold as collateral. Commercial banks hold about three fourths of the resources of the financial system. which determines the viability of the rehabilitation plan and appoints a Mancom or a rehabilitation receiver to implement the proposal if approved. profitable companies from going public. could take an indefinite period.4 3. The law on suspension of payments envisions resetting the corporation’s business for a temporary period to prevent its irreversible collapse. the litigation process.
Equity instruments include common stocks. this is because. but not to the same extent as it did in other Asian economies. Philippine companies were less leveraged. compared with other economies. Equity financing through IPOs was active. the minimum required to qualify as a public corporation. As a result. preferred stocks. Even in the real estate sector.5 billion). especially short-term debt.000 companies. is far ahead of the flock. compared with Malaysia ($186 billion). Korea) ($143 billion).7 billion. Of the 221 companies listed in the Philippine Stock Exchange in 1997. the Republic of Korea (henceforth. however. Foreign funds were wary of the Philippine stock market because of its limited liquidity.4 billion (or $59 million using the average exchange rate). about the size of Thailand’s. inflation. The stock market was depressed up to the early 1990s. companies expanded only at a moderate pace. They invested in only a few large companies whose shares were relatively liquid. Table 3. The crisis affected the Philippine corporate sector. However. The corporate sector raised a substantial amount of . and less engaged in risky investments. Vol. most listed companies are controlled by their five largest shareholders. The period 1993-1997 was one of lower inflation and declining lending rates. while interest rates were at high levels and volatile. Rising stock prices during the Ramos administration reflected to some extent the business optimism. From the 1970s up to the early 1990s. Most publicly listed companies issue only up to 20 percent of total shares to the public.200 Corporate Governance and Finance in East Asia. In part. 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. and fiscal management were among interrelated factors explaining the underdeveloped state of the Philippine financial market. the country experienced double-digit inflation. was one of the smallest in the region at $47. only 84 had sales large enough to be placed in the top 1.14 shows that the average volume of daily trading in 1997 stood at P2. Foreign portfolio investments also remained small. Malaysia. and convertible securities. The Government financed its chronic fiscal deficits by issuing short-term Treasury bills. Korea and Thailand). The market capitalization of the Philippine stock market in August 1997. Most companies invested only in projects that met hurdle rates as high as 20 to 30 percent and had short payback periods. less exposed to foreign debt.. The Philippine stock market is not a liquid market. Interest rates. II sector. and Indonesia ($61. The ratio of market capitalization to GDP over the last 15 years put the development of the Philippine stock market at par with other developing markets in the region (e.g.
1983-1997 Daily Trading Volume (P million) — — — — 129.6 1.7 0.8 102.4 1.515.4 728.7 41.088.7 391.1 88.351.8 1.9 1.5 72.2 61.0 0.6 261.9 2.545.2 0.2 925.5 26.6 1.906. .121.5 16.474.2 ($ million) — — — — 6.2 57.251.3 2.3 0.1 5.9 608.0 0.8 1.8 799.7 1.5 571.2 59.445.1 0.2 297.171.686.9 114.1 0.3 158.5 1.7 207.3 59.386.2 1.7 2. P billion) 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 19.1 524. Note: Combined transactions of Makati and Manila Stock Exchanges are not available for the years 1983 to 1986.Table 3.0 1. P billion) Gross Domestic Product (current prices.5 12.2 0.2 1.421.9 12.0 161.0 2.4 9.0 0.077.3 — = not available.373.3 314.8 0.248.9 2.14 Philippine Stock Market Performance.3 Market Capitalization (year end. Source: PSE databank.692.2 3.3 4.5 Year 369.9 682.4 Ratio of Market Capitalization to GDP 0.8 1.3 0.5 1.1 0.1 0.
sells these commercial papers through brokers. The corporate bond market was stunted. This is because only companies with strong capitalization and predictable cash flows such as public utility companies can issue bonds. The largest buyers have been commercial banks. However. Debt securities include commercial papers and corporate bonds.2 Patterns of Corporate Financing The study looked at retained earnings. moreover. are in a position to provide such discipline. The underwriter. of which 85 percent was raised from 1993 to the first half of 1997. However. corporate bond issuing was even more limited. and high transaction costs. because business groups often own large commercial banks. Corporate bonds are another type of debt securities. discounting of receivables. about 127 companies went public with a total value of offerings of about P134. Debt instruments include negotiated credits and debt securities. and the dominance of large commercial banks. Vol. which in most cases is an affiliate of the issuing company. and inventory financing.6 billion. issuing companies had to undergo a process of review and credit rating by the Credit Information Bureau Inc. lack of competition among financial institutions. by virtue of their large stakes in the financial system. Only the commercial banks. asset-backed credits. Under SEC regulations. new equity. From 1988 to 1997. a strong regulatory system for bank supervision is imperative. Because existing shareholders wanted to retain their proportionate control over their companies. Negotiated credits. the rights issue was a popular way of raising equity capital.. Few companies offer preferred stocks because the Philippine tax system does not allow tax deductibility of dividends on preferred stocks. which ultimately influences the pricing of commercial paper issues. Only a few large companies floated commercial papers because of the limited market. by volatile interest rates and the absence of a secondary market. leases.4. which buy commercial papers either for their own account or for their clients. The measures used in the analysis are: . II equity capital through IPOs during the stock market boom from 1993 to the first half of 1997. tight regulations.202 Corporate Governance and Finance in East Asia. 3. include bank credits. which were the principal source of corporate financing in the Philippines. The picture of the financial system that emerges is thus one of limited capital markets. Capital markets cannot provide the market discipline that corporate investors need. and debt as sources of corporate financing by using flow of funds analysis.
4 0.3 0.3 0.3 0.1 Average 1. 1988-1997. All Companies Financial flows data were derived from the SEC-BusinessWorld Annual Survey of Top 1.4 0. the SFRT was low at Table 3. It measures a company’s capacity to finance growth in fixed assets by internally generated funds.000 Corporations in the Philippines from 1988 to 1997.3 0.1 0.5 0. .5 0.8 0. On the other hand.8 0.5 0.5 0.2 0.4 0.9 0.15 Financing Patterns of the Corporate Sector.1 0.6 0.8 0. 1989-1997 Financing Indicators SFRF SFRT NEFR IDFR IEFR 1989 1990 1991 1992 1993 1994 1995 1996 1997 1.4 0.5 0. during this period. the average SFRF was high at 109 percent.0 0.2 0. By definition.15.5 2. Incremental equity financing ratio (IEFR): ratio of changes in shareholders’ equity inclusive of retained earnings to changes in total assets.Chapter 3: Philippines 203 (i) (ii) (iii) (iv) (v) Self-financing ratio of fixed assets (SFRF): ratio of changes in retained earnings to changes in fixed assets. Incremental debt financing ratio (IDFR): ratio of changes in total liabilities to changes in total assets.7 0. it is one minus IDFR.2 0.9 0.3 0. It measures a company’s capacity to finance asset growth by equity capital.2 0.5 0.5 0. Self-financing ratio of total assets (SFRT): ratio of changes in retained earnings to changes in total assets.9 0.5 0.4 1.4 0.6 0.6 0.4 0.9 0. As shown in Table 3.3 0.2 0. It measures a company’s capacity to finance asset growth by internally generated funds.1 0.4 0. Retained earnings were sufficient to finance the entire growth of fixed assets in the corporate sector.3 0.5 0. New equity financing ratio (NEFR): ratio of changes in stockholders’ equity (excluding retained earnings) to changes in total assets.000 Corporations in the Philippines.0 0.5 Source: SEC-BusinessWorld Annual Survey of Top 1.1 0.1 0. It measures a company’s reliance on borrowings in financing asset growth.
1 a Excludes negative balances. This was mainly caused by the declining contribution from retained earnings.and foreign-owned.3 0. 1991.204 Corporate Governance and Finance in East Asia. II only 19 percent. As a result. Companies financed fixed assets from internal sources in hard times. except in 1991. Source: SEC-BusinessWorld Annual Survey of Top 1.2 (0.3 0. Vol. 1989-1997 Financing Indicators SFRF SFRTa NEFR IDFRa IEFRa a Publicly Listed 1. for all three types of companies—publicly listed.5 Foreign-Owned 1.7 0. retained earnings declined and few new equity investments flowed into the corporate sector.3 0. The corporate sector consistently relied on debt and new equity to finance asset growth throughout the period.5 0. internal funds were not a significant source of financing growth in total assets. Retained earnings were the least important. privately. with debt providing 93 percent of the financing requirements. . reflecting the capital flight caused by political instability in the early 1990s.16. In 1997.9 0. the SFRF was higher.000 Corporations in the Philippines. The corporate sector used new equity to finance 32 percent and new debts to finance 49 percent of growth in total assets. It can also be observed that the relative importance of stockholders’ equity (including retained earnings and new equity investment) was declining and that of debts increasing in financing the growth of the corporate sector from 1991 to 1997. In periods of an economic crunch such as in 1989. 1988-1997. the level of corporate leverage increased. when it financed 45 percent of it. Corporate Financing by Ownership Type As shown in Table 3.3 0. In all the years.5 Privately-Owned 0.16 Corporate Financing Patterns by Ownership Type.8 0. except for foreignowned companies that had a negative new equity financing ratio. debts were the most important source of financing.6 0. Total assets grew by 23 percent that year. implying that internal funds were far from sufficient to finance growth in total assets. and 1997. suggesting that there was a deterioration of financial performance in the Philippine corporate sector in the years running up to the crisis. There were significant year-to-year variations.2 0.0) 0. On Table 3.
3 13.6 48.3 51.3 12.9 38.2 42.7 7.9 16.8 26.4 100.Chapter 3: Philippines 205 average.1 7.and foreign-owned companies.1 49.7 13.5 9.5 0.7 23.0 53.8 0.17 Composition of Assets and Financing of the Publicly Listed Sector.1 15.2 100.9 3.000 Corporations in the Philippines.5 27.7 100. 1988-1997.4 100.0 9.8 39.8 3. contributing 90 percent of growth in total assets. It presents a composition analysis of assets and financing sources for the period 1992-1996.1 10.9 16. publicly listed companies relied more on new equity financing than privately. This financing pattern supports the earlier finding that foreign-owned companies had the highest leverage among the three types of companies.4 41.0 13. compared with 47 percent for publicly listed companies and 55 percent for privately-held firms.17.4 10.6 43.0 100. Foreign-owned companies relied more heavily on debt financing.7 2.0 9.0 12.5 41.2 12.0 10.0 1994 19.1 13.6 26.4 100.9 12.3 10.0 6. especially bank loans.0 Source: SEC-BusinessWorld Annual Survey of Top 1.0 38.2 100.3 12.8 46.2 51. significantly Table 3.7 2.3 11.9 100.8 16.7 13.0 1993 14.5 12.3 48.0 9.4 100.3 12.4 2.8 38.0 9.5 16.6 37.9 4. 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 14.8 3.3 10.1 9.8 0. .4 43.8 4.4 12.0 1995 1996 13. The sector built up its short-term debts.7 4.8 17.0 8.9 0.8 51.6 48. A breakdown of the financial structure of publicly listed companies measured in balance sheet items is shown in Table 3.3 4.9 16.2 3.4 2.1 50.6 0.9 24.2 3.0 10.8 100.4 3.
The SFRF for independent companies would have been even lower if the highly profitable foreign-owned companies were excluded.2 0. For these two reasons. . The traditional measure of liquidity. 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.18 Financing Patterns by Control Structure. respectively. compared with an average of 54 percent for independent companies. The normal standard liquid position is a current ratio of 2 or higher.45 in 1996. their inherent ability to pool risks.18.1 0. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Group Member 1.206 Corporate Governance and Finance in East Asia. and economies of scale in fund raising. the current ratio.5 Excludes negative balances Source: SEC-BusinessWorld Annual Survey of Top 1.000 Corporations in the Philippines. Group companies financed an average of 45 percent of growth in total assets by debt. 1988-1997.3 0. On average. the average SFRF of business groups was higher compared with that of independent companies. Table 3. Vol. indicating that many publicly listed companies were likely to be in a tight liquidity position.3 0. II in 1996 and became more vulnerable to the financial crisis in 1997. Further.5 0.9 0. group companies were less reliant on debt financing than 13 Defined as total current assets divided by total current liabilities.5 0. as opposed to 94 and 30 percent.6 Independent Company 0.13 was at 1. As shown in Table 3. for independent companies.3 0. Group companies were generally more profitable than independent companies. group companies usually financed their investment in member companies by equity rather than debt. the easier access to external credit. Corporate Financing by Control Structure Conglomerates have certain advantages in financing because of the opportunities offered by the internal capital markets.
08 and SFRT of 0.2 0. equity financed 42 percent of incremental asset growth. Large firms consistently increased their reliance on debts from 1994 to 1997.5 Excludes negative balances. With assets growing at a fast pace during this period.9 0. Large companies’ IDFR of 0. The lower SFRF for large companies may be caused by their larger outlays for growth in fixed assets. These years were 1991 with 110 percent.8 0.2 0. The medium-sized companies’ high debt financing ratio was due mainly to three years of complete reliance on debt to finance growth. Excluding . Table 3.76 for small companies and 0.6 0. On average. 1993 with 96 percent.3 0. and 1997 with 131 percent.3 0.55 was substantially higher than the small companies’ 0.Chapter 3: Philippines 207 independent companies. The corresponding ratio was 0.88 for large companies (Table 3. There was also increased reliance on debt financing. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Large 0. 1988-1997. These results support the earlier finding that the leverage of business groups was lower than that of the independent companies from 1988 to 1997. medium-sized companies used more debts.20).1 0. with an average of 3.000 Corporations in the Philippines.47.06. compared with 55 percent for large companies and 47 percent for small ones.2 0.5 Medium 3.19).3 0. averaging 61 percent of growth in total assets.19 Financing Patterns by Firm Size.6 0. Source: SEC-BusinessWorld Annual Survey of Top 1.5 0.50 (Table 3.4 Small 0. Corporate Financing by Industry The manufacturing sector had an average SFRF of 1. Corporate Financing by Firm Size SFRF was highest for medium-sized companies.
The utilities sector showed weaknesses in internal fund generation in 1989-1994.3 0.208 Corporate Governance and Finance in East Asia. 1989-1997 Financing Indicators Manufacturing SFRFa SFRTa NEFR IDFRa IEFRa 1. Low incomes diminished the equity financing position of the manufacturing industry toward the crisis year.3 0.20 Financing Patterns by Industry. SFRF for the sector averaged 0.6 a Excludes negative balances. In the eight years preceding the crisis.5 Utilities and Real Estate Services and Property 0.27. the incremental equity ratios of the industry were high. The real estate industry financed its growth by substantial equity funds.79 and in 1997 at 0.3 0. Table 3.2) 0.1 0.91.6 0. II 1991. the manufacturing industry financed 57 percent of its total asset growth by debt. . increasing to 0. Its SFRF and SFRT were volatile because of chronic losses and reduction in fixed and total assets. the total debt ratio was much higher in 1996 at 0.58 and SFRT of 0. the industry generated internal funds.47 two years later. Source: SEC-BusinessWorld Annual Survey of Top 1. Vol. Equity financed an average of 62 percent of total asset growth. The construction sector was a heavy user of debt financing.04. with an SFRF as low as 0.6 0.32. when debts declined. The sector had the highest leverage among all industries that year. debt financed about 78 percent of asset growth in real estate. ranging from 41 to 118 percent. During the crisis year. Incremental equity financing amounted to an average of 44 percent of total asset growth. achieving an average SFRF of 3.5 0.4 Construction 0. while SFRT averaged only 0. 1988-1997. While this level is considered prudent.5 (0. Equity financed the rapid expansion in the industry’s assets in the period 1994 to 1997.6 0.4 0. Since the real estate boom coincided with that of the stock market. The situation improved beginning 1994. The effects of the crisis of 1997 were adverse. Excluding 1997 when fixed assets declined.4 0.4 0. Total liabilities increased partly as a result of the local currency devaluation and financed all of asset growth for the year.5 0. Up to 1997.3 0.000 Corporations in the Philippines.29. many of the leading real estate companies successfully went public during that time.4 3.7 0.
at the same time. 14 See for example Michael Jensen (1993).21 Ownership Concentration. and Performance Previous studies on corporate governance have often associated ownership concentration with heightened risk-taking by companies.14 Large shareholders may borrow excessively to undertake risky projects.008 5.860 Leverage = the ratio of total assets to total equity.421 0. ROE = return on equity. Source: Author’s estimates based on the PSE databank.769 0. alternatively. These results suggest that companies with higher ownership concentration tend to be more highly leveraged and.130 ROA 0. ROA = return on assets. was regressed against measures of profitability and of financial leverage.3 Ownership Concentration. Large shareholders may also overuse financial leverage to avoid diluting ownership and control. creditors bear the consequences. ownership concentration = the total shareholdings of the top five shareholders. 1992-1996. the coefficient of the ownership concentration measure in all the three regressions is positive and statistically significant.009 5. Table 3. Using the PSE database. and leverage. As shown in Table 3. and the Failure of Internal Control Systems.004 3.00125 2.Chapter 3: Philippines 209 3. ROE. Three regressions were run with the shareholding of the largest five shareholders as an independent variable and ROA.21. Exit. . Financial Leverage.287 0. the degree of ownership concentration. measured by the percentage of shareholdings of the largest five shareholders.00056 1. as the dependent variable. and Financial Leverage Dependent Variable Item Coefficient of Ownership Concentration T-statistics Adjusted R-squared F-statistics ROE 0. Journal of Finance 48: 831-880. The Modern Industrial Revolution.4.230 Leverage 0. more profitable. Profitability. and financial leverage are all positively and significantly related to the degree of ownership concentration. ROE. while if it fails.00036 2. knowing that if an investment turns out to be successful they could capture most of the gain. ROA.
the growth in foreign investments fueled that of the manufacturing and services sectors in the years preceding the crisis. which averaged 4. the country was less dependent on foreign private capital. Net trades in goods and services averaged a deficit of 4. the economy still showed vestiges of its import-dependent and substituting character. and agriculture at 21 percent. The country experienced balance of payments surpluses but these were due to transfers.210 Corporate Governance and Finance in East Asia. notably remittances of overseas workers. but its share had been declining by 4 percent per year since 1995. Manufactures accounted for about 85 percent of exports. more than half (52 percent) of exports were semiconductors. The structure of the economy may be understood by looking at its sectoral composition and export competitiveness.” that is. Compared to other East Asian crisis-affected countries. the country’s GDP growth pace indicated that it did not have a “bubble economy. industry at 34 percent. Historically. Vol.5. with commodities accounting for the balance. Commercial and industrial activities in the country were largely oriented to domestic markets.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. Although much lower than those of other Asian countries. II 3.8 percent of GDP from 1995 to 1997. Garments was the second largest export sector at about 9 percent. foreign investments in the country have been low. raw materials. In 1997. In sum. with a narrow exporting industry base. About 80 percent of imports were capital goods (particularly power generating and telecommunications equipment). The export sector had a very narrow breadth. The Government explained that the country had “sound economic fundamentals” but that the problems were caused by “contagion.” The Government’s judgment that economic fundamentals were strong was based on stable growth rates. and intermediate goods. their growth gathering momentum only beginning in 1992. 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.5 percent per year from 1992 to 1997.5 3. Exports were growing at about 20 percent per year in the three years preceding the crisis. Net investment inflows were $3. Because of limited local capital. an overexpansion of capacities. The largest contributors to GDP were services at 43 percent.5 billion in 1996 and grew at an average of 48 percent per annum from 1992 to 1996. After a .
Economic performance during 1992-1997 was characterized by an average growth rate of real gross national product (GNP) at 3. the discipline of the loan moratorium and the restructuring of the country’s loans to long-term maturity kept this ratio below 100 percent up to September 1997. The adverse impact of the crisis in most Asian countries was proportional to the amount of short-term foreign debts relative to net international reserves. and a relatively healthy banking system.Chapter 3: Philippines 211 long period of debt moratorium and restructuring that started in 1983 and ended in 1991. In the Philippines. while sales grew by only 20 percent per year. Total debts were only 52 percent of assets or 108 percent of equity. Financial institutions called on their shortterm loans and shortened the maturity of existing loans. however. assets grew at a compound annual rate of about 31 percent. The lessons from debt restructuring became the basis for the Government’s economic policies. shows that investments of the corporate sector were growing at a faster rate than sales revenues in the years immediately preceding the crisis.3 percent. depended on the quality of the corporate sector’s investments. the Government restructured its debts into longer tenors with a maximum of 25 years. Five years of stable growth before the crisis enabled the country to build its net international reserves to $10. Eventually. a government fiscal surplus from 1994 to 1997. Since the regional financial crisis was triggered by the loss of confidence in some East Asian economies by foreign creditors and investors. the country and the corporate sector had no access to foreign currency debts from the international financial market. fueled also by successful IPOs during the stock market boom of 1993-1996. During this time. a positive balance of payments from 1992 to 1996. Closer analysis.5 percent. The corporate sector was in a relatively stable financial condition around the time of the crisis. average ROE was 13. in turn. the ratio of short-term debts to international reserves dipped below 100 percent beginning June 1998. which.1 percent. an average Treasury bill rate of 13. an average inflation rate of 7. From 1988 to 1996. resulting in stability in the short-term debt to reserves ratio. adjustments were focused on the quantity and quality of the banking system’s corporate loans. Prudent fiscal management and controls on foreign borrowings were part of the adjustments required by IMF and foreign creditors. the Government sought stability and achieved this in 19921997. After hovering in the range of 100 to 127 percent. .8 percent.6 billion as of March 1997. Profitable operations since 1992 had allowed it to build equity. unlike their counterparts in the region. The Central Bank conserved international reserves by allowing the local currency to float within a wider trading margin. From 1993 to 1997.
303 23.06. II The corporate sector indeed overexpanded after 1993 like its counterparts in the region. It rose to $2. These patterns in investment and financing are similar to those of other countries in the region.073 (406) 121. . It is understandable then that the effect of the Asian financial crisis on the Philippines was correspondingly that of a negative “contagion. Data for 1998 cover only January-August. In 1997.71. Debts financed a large part of this expansion.101 92. 1997 = 29. Net foreign portfolio investment amounted to $1. Foreign investments in the Philippines have not been as high as the inflows to other Asian countries—and this.22 Foreign Investment Flows.22. It financed 26 percent of corporate capital growth.0 1996 3. Net foreign investments more than doubled from 1995 to 1996 but declined by 78 percent in 1997 (Table 3.5 billion in 1995. 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.2 Impact of the Crisis on the Corporate Sector Aside from the foreign exchange adjustment.47. net FDI remained stable at more than $1 billion. Most of this leverage happened during the boom years in the region. But portfolio investment amounting to $406 million flew out of the Philippines. or 114 percent of net foreign direct investment (FDI). In sum. Table 3.22).4 1997 762 1.212 Corporate Governance and Finance in East Asia. Sources: Bangko Sentral ng Pilipinas and SEC.” 3.749 26.074 2. mitigated the effects of the pullout and liquidation of investments in the aftermath.485 145. The debt level of the Philippine corporate sector in 1997 was low by Asian standards but still high by developed country standards. 1998 = 41. precisely.0 1998 739 555 328 69. 1995-1998 Item Net Foreign Investments ($ 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 1.5.7 Note: Peso-dollar exchange rates used are: 1995 = 25.517 1.609 1. the other immediate impact of the crisis was that on foreign investment flows.300 1. Vol. but to a lesser degree.718 30. 1996 = 26.101 billion or 196 percent of net FDI in 1996. growing by about 34 percent per year from 1994 to 1997.650 32.
Loans outstanding of commercial banks declined by the first quarter of 1998. new borrowings financed asset growth. meanwhile. then rose to a high of 22. Lending rates were well above the 20 percent level from July 1997 to March 1998. The interest rates on Treasury bills. When the Treasury bill rates eased in March 1998.2 percent was barely above inflation rate. and the wholesale and . ROE at 6.369 billion. A number of small banks closed but they represented less than 1 percent of the financial system’s total resources. they were willing to restructure and renegotiate existing loans by corporate borrowers. the corporate sector became vulnerable to loan calls and high interest rates. The real problem of the corporate sector during the crisis was the rise in interest rates.Chapter 3: Philippines 213 Corporate financial performances and conditions deteriorated during 1997. Although corporate borrowers were not highly leveraged. the commercial banking sector’s capital remained strong at 17. By March 1988.7 percent in January 1998.9 percent.2 percent in November 1997. With the increase in borrowings and reduced liquidity. The banking system was able to absorb the impact of the crisis primarily because of its strong capital position. and leverage increased to 149 percent compared with 109 percent in 1996. The resources of the financial system that year totaled P3. By October 1998. Because commercial banks were strongly capitalized. lending rates also came down. Companies deferred investments in new fixed assets. with commercial banks holding P2. the sectors with the highest outstanding loans had reduced their credit exposures. albeit at current market interest rates. in turn. The combined effects of shrinking demand and high interest rates reduced the corporate sector’s demand for loans. suggesting that commercial banks required a higher premium at about the height of the crisis but not beyond. sparking a rise in interest rates on corporate loans. Manufacturing reduced its loans outstanding by 11 percent from October 1997 levels. Average bank lending rates climbed to their peak of 25. Net profit margins were at a 10-year low at 4. Bank loan pricing was based on the bellwether 91-day Treasury bill rates rather than inflation. they could not initiate a large reduction of their loans because these in part financed long-term growth in assets. Loan calls. which held about 75 percent of the assets of the financial system in 1997.513 billion. in varying degrees for each sector. Bank spreads over Treasury bill rates increased in 1997 but were within the range experienced in the past.2 to 28. depended on the liquidity and capital position of commercial banks. ranged from 11 to 13 percent from 1993 to July 1997.3 percent of assets. Because of weak internal fund generation.
and set up a hedging facility for borrowers with foreign currency-denominated loans.3 Responses to the Crisis Government Responses The Government’s policy and regulatory responses to the crisis focused on monetary and credit issues.3 percent in December 1997. But the Philippine banking system had gone through worse crises in the past. to reduce their lending spreads over the 91-day Treasury bill rates from 3-8 percent to 1.214 Corporate Governance and Finance in East Asia. The Central Bank adopted other measures to strengthen the financial system. real estate loans averaged 11. single-digit NPL ratios began only since 1989.6 percent in June 1998. II retail trade sector. 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. However. This “voluntary agreement” partly explains why the loan spreads of banks were within the range of recent experience. The latter measure was especially beneficial to companies with unhedged foreign currency loans from commercial banks. These peaked at 14. as with its counterparts in other Asian countries. including (i) a regulatory limit of 20 percent on banks’ loans to the .9 percent of bank loan portfolios. These figures show that adjustment problems were industry-specific and that the real estate industry. was a problem sector.5 percent by September 1998. loans outstanding of the real estate sector increased by 11 percent from June 1997 to June 1998. set limits on overbought/oversold foreign exchange positions of banks. The move retained the liquidity position of banks but lowered their cost of reserves. Vol.5-6 percent. 3. This allowed the Central Bank to convince the banks. the ratio increased to a high of 11. by 12 percent. and the financial system. In March 1997. The Central Bank introduced regulations on foreign exchange trading to control speculation and nondeliverable forward contracts. and its experience of low. through the Bankers’ Association of the Philippines. The pattern indicates that real estate loans were of substandard quality but banks had contained the problem by mid-1998. As for nonperforming loans (NPLs). 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. the fiscal position. and subsequently went down to 13. thereby reducing overall intermediation costs.5. Still.
The policy directions and actions taken by the Government appear to have ushered in recovery. and the legal framework for reorganization and liquidation conditioned its response to the crisis. Publicly listed Philippine companies could also be restructured through takeovers by local and foreign investors. In response to calls for lower bank intermediation costs. In the case of PLDT. (ii) shortening the period for classifying unpaid loans as past due from three months to one month. The acquiring company. Takeovers in the past involved cooperative negotiations between purchasers of a target company and family-based large shareholders. Average Treasury bill rates have cooled since mid-1998. subcontracting and outsourcing. Responses of the Corporate Sector The corporate sector’s financial position. changing technologies. came up with a rehabilitation plan by May 1999 that was found acceptable to all parties. Large companies with heavy loan exposures such as Philippine Airlines Inc. the Asian crisis opened a unique opportunity for foreign investors.Chapter 3: Philippines 215 real estate sector. (v) improving disclosure requirements on the financial position of banks. PAL. The economy avoided a recession in 1998 and achieved 3. The real estate portfolio of commercial banks also declined and was well below the Central Bank’s regulatory ceiling by March 1998. bank loan rates have also come down. (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. its accessibility to foreign capital. A 40 percent devaluation of the Philippine peso lowered the purchase price of PLDT to foreign investors. and giving up noncore businesses.6 percent growth in 1999. First Pacific Corporation. Financially strong companies were able to survive the crisis by effecting such internal restructuring. and (vi) issuing guidelines on duties and responsibilities of banks’ boards of directors for improved quality of bank management. With prudent monetary management. (iii) fixing loan loss provisions of 2 percent of the gross amount of loan portfolio on top of individually rated bad loan accounts. the largest telecommunications setup in the Philippines. was known to have a policy . took more action. which was privatized with the Lucio Tan group gaining control and the Government retaining minority ownership. consolidating business units. the Government kept inflation below 10 percent. 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. (PAL). With its weakened financial position.
II of investing to control companies that are dominant players in their industries. he restructured the company toward its core brewery business and sold off local and foreign subsidiaries. eventually took over PLDT and announced a restructuring plan for the entire group of companies. 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. SMC is another widely-held company managed by a minority shareholder. 3.6 3. however.216 Corporate Governance and Finance in East Asia. Although considered the prime industrial company in the Philippines. Vol. One mode was the outright purchase of shares in the open market. Ownership is highly concentrated and a few dominant players control major industries. When companies are highly profitable.6. the Cojuangcos. By itself. A second method was to purchase the shares of other large minority shareholders. at a premium over the market price to reflect the value of management control.1 Summary. concentrated ownership of companies is not equivalent to weakness in corporate governance. First Pacific. Eduardo Cojuangco was able to assert his ownership of shares taken over by the Government during the transition of power in 1986. the Soriano family. In a legal process that ended in his takeover of management. and Recommendations Summary and Conclusions The Philippine corporate sector has been shaped by the country’s economic and industrial development policies. controlling shareholders can capture these profits by excluding public investors from ownership. Conclusions. is whether there are sufficient safeguards to prevent controlling shareholders from . 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. Corporate governance is conditioned by the high ownership concentration of these large companies. the stock price of PLDT was buoyant during the takeover period. Consequently. When Cojuangco took over. First Pacific could have acquired sufficient shares to take control of PLDT in three ways. The question. Its stock price and returns to shareholders had stagnated. A third method was to make a formal tender offer to PLDT’s controlling minority shareholders. SMC had lagged behind other groups of companies such as Ayala Corporation in financial performance for some years. using some or all of these means.
Performance was. ownership of banks by business groups. oligopolistic market structures. Privately-owned companies. companies that are members of family-based conglomerates had higher returns and lower leverage than independent companies. Financial institutions are not significant shareholders. Ownership of publicly listed companies is highly concentrated. Analysis of corporate financing by ownership . The corporate sector consistently relied on internally generated funds and equity before resorting to borrowings.Chapter 3: Philippines 217 expropriating the wealth of minority shareholders through aggressive and risky investment. The result is that corporate governance depends only on internal controls. 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. passive independent auditing. with the real estate and public utilities industries standing out for their pronounced cyclical patterns. Returns to capital exceeded inflation rates. Corporate governance should be viewed in the context of an increasing presence and growth of large shareholders-centered conglomerate business organizations. Forming business groups appears to be a viable means of competing because this allows for more efficient organization and utilization of resources of large controlling shareholders. By ownership structure. By control structure. foreign companies were the most profitable but highly leveraged. and the lack of market for corporate control. minority shareholders need to be protected by external control mechanisms. influenced by industry characteristics. The financing pattern of the corporate sector was influenced by the tight financial conditions prevailing in the country up to 1992. to some extent. an underdeveloped capital market. With large shareholders in control. medium companies showed higher profitability than large and small ones. the most numerous in the corporate sector. This study analyzed trends in corporate performance and financing in relation to corporate governance from 1988 to 1997. By size. Leverage was within Asian norms but above developed country standards. were the least profitable. Business groups occupied seven of the top 10 and 25 of the top 50 largest corporate entities in the Philippines in 1997. The five largest shareholders have majority control of an average publicly listed company. an ineffective insolvency system. The Philippine corporate sector was relatively efficient in investing and financing compared with other countries affected by the Asian crisis. This study points out weaknesses in external control mechanisms such as weak legal protection for minority shareholders.
Large. Publicly listed companies were responsive to investors’ requirements for prudent use of debts. and centralized management and financing. Ownership concentration was positively related to both returns and leverage. and leverage were all positively related to the degree of ownership concentration. the amount of pressure from stock market investors and PSE (for publicly listed companies in the group). Larger disparities in control over cash flow rights imply higher incentives for large shareholders to (i) expropriate wealth of shareholders not belonging to the controlling group and (ii) invest in empirebuilding and high-risk projects. and the extent of supervision of outside institutions such as independent auditors and SEC. The extent of governance problems depends on internal control policies of the controlling shareholders. Family-based business groups have focused their investments in industries where their superior financing capacities and political/social influence give them unique advantages. selective public listing of companies in the group. Large companies owned or controlled by business groups tend to dominate their industries. with the foreign-owned companies found to rely more on borrowed funds. superior profitability. The pyramid model is useful for centrally managing smaller companies. 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. ROA. Vol. as typified by the Ayala Group. A commercial bank is an important part of most business groups. statistical analysis of company-level data revealed significant relationships between corporate performance and corporate governance. and sustained growth. ROE. II type gave similar results. the bank usually accounted for a large share of each group’s net profits. Even in cases where the group owned only a minority share of a commercial bank.218 Corporate Governance and Finance in East Asia. The difference between management control and ownership rights is usually substantial. Companies whose large shareholders have higher degree of control tend to borrow more but generate better returns. Such structures result in control by large shareholders through disproportionately smaller investments in equity ownership. . A business group is an effective business organizational model for achieving leadership in industries. After controlling for industry effects. Internal financial markets operated by business groups allowed them to optimize their financial resources at lower external debt levels. family-based shareholders gain control by such means as the setting up of holding companies. Business groups with pyramiding structures heighten the issue of corporate governance.
That is. decisions by large sharehold- . the government budget in surplus. and sound overall creditworthiness. 3. Specific actions recommended are described below. strong capital position built on IPOs in a buoyant stock market. Promoting a Broader Ownership of the Corporate Sector The highly concentrated ownership of the publicly listed corporate sector should be a concern of SEC and PSE. The corporate sector accessed the foreign debt market only in the mid-1990s because of the country’s long-drawn debt moratorium. are to be removed and transferred to courts.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. This law is flawed in concept because it supplants a market-based credit agreement with a political process. The Central Bank responded by improving the liquidity of the system and by establishing conditions for bringing down interest rates on bank loans. The crisis caused a tightening of credit to the corporate sector and a spike in interest rates. Under the new Securities Regulation Code enacted in 2000. there were sharp rises in the number of bankruptcies and petitions for debt relief. a strong international reserves position. adversely affecting companies’ operations and financial position. For example. and a market-oriented policy environment. SEC officials. low inflation. including suspension of payments. mostly by highly leveraged companies and speculative investors in real estate. decide on the financial future of a troubled debtor. Still. SEC’s quasijudicial functions. A number of large debtors petitioned SEC for rehabilitation under procedures set by PD 902-A. The Central Bank imposed strict limits on real estate lending.Chapter 3: Philippines 219 The financial crisis came when the Philippine economy was in a relatively strong financial position. resulting in the banks’ accelerated restructuring of troubled debts in this sector. 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. There are systemic risks involved in highly concentrated ownership.6. rather than the banks that lent millions of pesos. 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. with recently restructured public debt.
inadequate disclosures. This may limit current practices of appointing prominent individuals and family members as directors. and (iii) increase the minimum required percentage of outstanding shares for public listing in the stock exchange from the present 10-20 percent. Another measure would be to impose a statutory limit on the number of directorships that one can accept. depending on the size of the company. Increasing the Statutory Accountability of Directors and Strengthening the Board System The Government should clarify statutory fiduciary responsibilities of the board of directors. and self-dealing. they serve to curb the powers of controlling shareholders. Strengthening Minority Shareholder Rights An issue that concerns minority shareholders is whether they have instruments—legal or ethical—that can prevent controlling shareholders from expropriating their wealth through risky investment and financing.220 Corporate Governance and Finance in East Asia. Clear legal accountability is a precondition for successful shareholder activism. Vol. insider information. Because independent directors tend to adopt the perspective of minority shareholders in board decisions. 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 help ensure this. This will enable SEC to enforce prudential requirements on management of companies and enable minority shareholders to pursue grievances against their boards. II ers often cause wide volatility in stock prices and invite reaction from creditors. the PSE Listing Rules require the appointment of a minimum number of independent directors in the board of publicly listed companies. It has suffi- . (ii) require disclosure of material changes in ownership. to 25 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. The adjustment should be made over a fixed period of time. SEC should strengthen disclosure requirements by issuing specific guidelines on minimum disclosures required for related party transactions. To strengthen the board.
raising the current two-thirds majority to a three-fourths majority. in areas of supervisory functions of the central bank.. and related interests. officers. reporting. in particular. (iv) require banks to follow international financial accounting. The following recommendations aim to further improve banking regulations and supervision in the Philippines: (i) limit shareholdings of nonfinancial companies in banks. (iii) adopt international standards of capital adequacy and ensure that banks comply with these standards. the board can easily muster the needed majority to approve the deal. (ii) set strict limits on lending by banks to affiliated companies.Chapter 3: Philippines 221 cient case history that can be used as a basis for tightening its disclosure requirements. 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. limit. Finally. It is encouraging that the newly enacted 2000 Banking Laws have introduced changes along these lines. the Corporation Code should be amended to impose sufficiently stiff penalties for self-dealings that patently expropriate the wealth of other shareholders. fit and . Because ownership is generally concentrated in five shareholders. e.g. By requiring sufficient disclosure and a 75 percent majority vote on such decisions. Impose severe penalties for any attempt by banks to circumvent this regulation. For example. The Government should improve its prudential supervision system to ensure that banks perform their role as external control agents of their corporate debtors. Minority shareholders have failed to use traditional venues such as the annual general shareholders’ meetings to discipline controlling shareholders that expropriate their wealth. Improving Financial Regulation and Strengthening Implementation The Asian crisis demonstrated the need to strengthen banking regulation. directors. They need legal empowerment such as higher majority voting requirements. current rules allow boards of directors to approve own-dealings or related party transactions by simple majority. and (v) closely monitor. and disclosure standards. or prohibit cross-guarantees by companies belonging to affiliated groups. and of banks in nonfinancial companies in order to avoid connected lending. prudential measures and regulations.
an active financial analyst community can begin to form. and external auditors. Other investors benefit from the information that analysts produce for these institutional investors as information technology makes their output a public good. By supporting the establishment and operation of institutional investors. Vol. Presently. The absence of institutional investors indicates that the legal and regulatory basis is inadequate. This way. and lending to DOSRI. SEC appears to be taking a primarily regulatory posture in the operation of investment funds. One is improved transparency and disclosure on specific items that potentially involve expropriation of wealth of minority shareholders. management. If institutional investors are present. In developed capital markets. 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. Investment and venture capital funds meet this description. institutional investors can be a driving force in providing market discipline to management. Its priority is to protect prospective fund investors from unscrupulous fund managers. Managements find that their investment and financing decisions affect stock prices and become aware of their responsibility to create shareholder value. II proper rule. SEC and PSE can help ensure that these external control agents provide market discipline even in companies controlled by large investors. foreign ownership of banks. Two measures should be adopted to promote shareholder activism. transparency. This investor profile has a “missing middle”—long-term investors who intend to participate in longterm growth of a company and who also trade shares depending on company performance. Promoting Shareholder Activism Promoting shareholder activism to encourage small shareholders to actively monitor management is an approach that has not been tried out in the Philippines.222 Corporate Governance and Finance in East Asia. institutional investors lead public investors in providing market signals to companies. Institutional investors impose market discipline by voting on strategic corporate decisions. The current law should expand class action suits to include management and . The other is the addition of provisions in the Corporation Code to facilitate class action suits against corporate directors.
Placing the means for prosecuting in the hands of minority shareholders may instill more discipline in controlling shareholders. Legal provisions for class action suits should cover self-dealing by directors. and dividend decisions. Companies are likely to remain dependent on bank financing if the authorities do not strictly enforce prudential lending regulations. Promoting Competition in Product Markets The Government should pursue industrial development policies that promote competition through the elimination of subsidies. entry . These groups have an incentive to gather technical expertise. There are existing institutions such as Dun and Bradsreet. where the threat of class action suits alone is sufficient to encourage quality decisions and behavior from management. Securities market development efforts should coincide with strict regulation of the commercial banking sector. And by issuing Government Treasury securities in longer tenors. Expanding Debt Securities Financing The Philippine corporate sector relies on bank loans because controlling shareholders do not want to dilute their control by issuing equities. guarantees. It should develop a medium-term yield curve for the corporate debt market by strengthening the Government bond market. Promoting the corporate bond market requires that the Government develop trading systems and services of credit risk rating of corporate issuers. Philippine Government Treasury bonds should provide bellwether rates for corporate bonds in the way that they have for short-term bank debts. 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. leadership. The present provision on class action suits is inadequate because shareholders view the process as ineffective and expensive. information disclosures. SEC should allow minority shareholders to be represented by activist groups. and Credit Information Bureau that can be the starting point of this effort. 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. and broad-based political and popular support to pursue possible cases involving expropriation of minority shareholders’ wealth. the Government could develop the market for future issues of corporate bonds. their directors and management.Chapter 3: Philippines 223 auditors. and the external auditors.
The resulting absence of a strong investor base makes share prices vulnerable to manipulation or insider trading by large shareholders. The increase in percentage of public holdings may be gradually implemented to enable the companies to adjust. Vol. II and exit barriers. 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. Efforts to reduce graft and corruption. PSE should campaign for top-tier companies to go public and work with SEC in encouraging publicly listed companies to expand their share offerings to the public. The Government’s competition policies should aim to facilitate the free entry and exit of domestic and foreign companies and regulation of anticompetitive practices.224 Corporate Governance and Finance in East Asia. Audited financial statements contain basic information about a company’s financial position and performance. and provide quality basic services should also be heightened. Improving External Audit Standards and Information Disclosure Effective external control in corporate governance requires accurate and timely information about companies. Penalties for poor conduct of auditing by independent . so that small. Another problem is the orientation of external auditors to the interest of large shareholders rather than public investors. Lack of liquidity deters institutional investors. The Government should also continue to improve infrastructure. and publicly listed companies trade barely the minimum number of shares required for public listing. Current disclosure requirements of SEC are not rigorous enough for 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. there is a need to increase the supply of quality securities from top-tier local companies in the Philippine stock market. improve enforcement of the rule of law. and various other forms of protection.and medium-scale companies can become more competitive relative to large companies. Increasing the Supply of Quality Equities in the Stock Market To promote the capital market as an external control agent in corporate governance. SEC should require that a larger percentage of publicly listed companies’ shares be sold to the public. PSE and SEC need to build a liquid and efficient market. Many large companies remain privately owned.
Reforming the legal framework for suspension of payments. reorganization. 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 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.Chapter 3: Philippines 225 auditors and the mechanism for imposing them are weak. Reorganization. the new law needs to be effectively implemented and enforced. Although the new Securities Regulation Code enacted in 2000 has removed some of SEC’s quasijudicial functions. Improving the Legal Framework for Suspension of Payments. and Liquidation. violators were made to pay only nominal penalties. SEC and PICPA need to formulate more specific disclosure standards. Instead. including the resolution of intracorporate disputes. The law on suspension of payments replaces a market-oriented solution with a political process. and liquidation of troubled companies should be made a priority of the Government. . it creates a moral hazard problem. and transferred these to courts. review the system of penalties on professionals involved in a company’s violation of disclosure rules. In spite of the many well-known cases of poorly audited financial statements that resulted in losses for investors. For that matter. and implement those standards and penalties rigorously.
Large Shareholders. Equity Ownership. P. Burkart.226 Corporate Governance and Finance in East Asia. and Corporate Diversification. March. Lang. July. Michael. Stijn. Discussion Paper. Fan. 1998b. 1999. and Larry H. George. Joseph P. Asian Development Bank. Joseph P. Lang. Manila: Asian Development Bank. World Bank. and Clifford Holderness. 1999. The Structure of Corporate Ownership: Causes and Consequences. Alba. M. Dennis. H. . Fan. Simeon Djankov. Pedro. Antonio. Lang. Claessens. 1985. 1994. Diversification and Efficiency of Investment by East Asian Corporations. David J. October. Key Indicators of Developing Asian and Pacific Countries 1998. Claessens. Emilio. and Simeon Djankov. Conference on Thailand’s Dynamic Economic Recovery and Competitiveness.. Simeon Djankov. 1989. 1998. Fan. Dennis Gromb. and Kenneth Lehn. World Bank. Stijn. Claessens. H. Simeon Djankov. Stijn. Denis. Agency Problems. 1998. Demsetz. Harold. Barclay. Lang. May. Working Paper. Quarterly Journal of Economics. World Bank. Simeon Djankov. Thailand: From Financial Crisis to Economic Renewal. P. and Larry H. and Atulya Sarin. and Larry H. Thailand’s Corporate Financing and Governance Structures: Impact on Firms’ Competitiveness. Expropriation of Minority Shareholders in East Asia. Ownership Structure and Corporate Performance in East Asia. Who Owns and Controls East Asian Corporations? Discussion Paper 2054. Journal of Financial Economics 25: 371-395. 1997. Asian Industrializing Region in 2005. Joseph P. Institute of Southeast Asian Studies. edited by Toida Mitusuru and Daisuke Hiratsuka. Claessens. Simeon Djankov. Journal of Finance 2 (1). 693-728. Lang. P. The Separation of Ownership and Control in East Asian Corporations. Tokyo: Institute of Developing Economies. Philippine Macroeconomic Prospects: The Next Ten Years. Stijn. 1998a. Vol. Claessens. The Philippines: Onward to Recovery. Bangko Sentral ng Pilipinas. 1999. World Bank.. Stijn Claessens. H. Monitoring and the Value of the Firm. XXIX. 1997. P. II References Abonyi. P. 1988. 1998c. Joseph Fan. Diane K. Journal of Political Economy 93 (6). Working Paper 2088. World Bank. and Fausto Panunzi. and Larry H. Private Benefits from Control of Public Corporations. Working Paper. Stijn. and Larry H. Jr. Vol.
Prowse. 1990. Oliver. 1983. 1990. 1976. Stephen. and David Scharfstein. Joseph C. 1995. Franco. Jensen. and David Gallagher (eds. Hart. Prowse. Stuart. Takeo. Jensen. Myers. Robert H. Philippine Stock Exchange Fact Book 1997. Review of Economic Studies 51: 393-414. Exit. Capital Structure and the Information Role of Debt. and Jeremy C. Michael. and Richard Ruback. Agency Costs and Ownership Structure. Corporate Finance and Takeovers. American Economic Review 85: 567-85. 1984.. and Merton Miller.Chapter 3: Philippines 227 Diamond. November. 1993. David S. Modigliani. Liquidity and Investment: Evidence from Japanese Industrial Groups. Journal of Finance 45: 321-350. Stein. Quarterly Journal of Economics 106: 33-60. Michael. Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management. The Market for Corporate Control: A Scientific Evidence. 1991. Corporate Structure. The Cost of Capital. Jensen. Theory of the Firm: Managerial Behavior. 1994. 1986. . Stephen. Journal of Financial Economics 5: 147-175. 1994 and Investment Guide 1997. and William Meckling. Michael. Journal of Financial Economics 27: 4366. American Economic Review 76: 323-29. Corporation Finance. 1958.). 1990. The Modern Industrial Revolution. American Economic Review 48 (3): 261297. Scharfstein. Journal of Finance 48: 831-80. Michael. Journal of Financial Economics 3: 305-360. Gestner. Institutional Investment Patterns and Corporate Financial Behavior in the United States and Japan. and the Theory of Investment. Financial Intermediation and Delegated Monitoring. 1998. Lufkin. Douglas. Milton. and the Failure of Internal Control Systems. World Bank. and John Moore. The Quarterly Journal of Economics. Anil Kashyap. Hoshi. Corporate Governance: Emerging Issues and Lessons from East Asia. Determinants of Corporate Borrowing. Euromoney Books. Harris. 1977. 1995. Journal of Financial Economics 11: 5-50. International Corporate Governance.. Jensen. F. Internal versus External Capital Markets. Agency Costs of Free Cash Flow. and Artur Raviv.
Internal Capital Markets and the Competition for Corporate Resources. Asian Development Bank. May. David. and Banking Lecture 17. DC. 1998. IFC/WB. Some Conceptual Issues in Corporate Governance and Finance. 1985. World Bank. Stiglitz. Mimeograph. Vishny. Joseph E. Ajit. Journal of Finance L11: 737-783.228 Corporate Governance and Finance in East Asia. Vol. Shleifer. Stephen. Journal of Political Economy 94: 461-88. 1998. 1997. Andrei. Vishny. II Prowse. Andrei. A Survey of Corporate Governance. 1. Journal of Finance 91: 1121-1139. No. East Asia: The Road to Recovery. Credit Markets and the Control of Capital. 2. Stein. and Robert W. The Structure of Ownership in Japan. March. . 1996. Jeremy C. Technical paper No. Singh. Credit. Journal of Finance LII. How Do Large Corporations in Developing Countries Finance their Growth? Corporate Financial Structures in Developing Countries. DC. and Robert W. 1997. No. November. 1. Journal of Money. Shleifer. 1992. Large Shareholders and Corporate Control. 1991. Washington. Webb. Washington.
The fixed exchange rate policy. The banking system.” After mounting an aggressive defense of the currency. had been plagued with prudential problems for a long time. the Stock Exchange of Thailand for its help and support in conducting company surveys. The author wishes to thank Juzhong Zhuang. with the currencies of Indonesia. annual short-term capital inflows to Thailand were equivalent to 7-10 percent of gross domestic product (GDP). But it also laid bare weaknesses in both the financial and corporate sectors. The crisis in Thailand stemmed directly from unsound macroeconomic policies and imbalances. As a result. the Thai baht came under pressure from speculative attacks. Faculty of Business. Korea). both of ADB. In the prelude to the 1997 crisis. poorly regulated and sheltered from competition. David Edwards. Malaysia. the Thai Government conceded and adopted a floating exchange rate regime. Thailand. For the period 1994-1996.4 Thailand Piman Limpaphayom1 4. Chonburi. It was inefficient in financial intermediation. short-term private debt obligations grew to about 60 percent of total private sector debts. Instead of serving as a buffer between the large inflow of foreign capital and the corporate sector. Thailand’s crisis exposed similar vulnerabilities in other East Asian economies. magnified the impact of these problems on the economy when the crisis hit.1 Introduction In May to July 1997. but also the stalling of East Asia’s “economic miracle. 1 Associate Professor. Asian University of Science and Technology. and Lea Sumulong and Graham Dwyer for their editorial assistance. the banking system merely validated the financial risks. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. The corporate sector also contributed significantly to the crisis. . The majority of these debts were not properly hedged. with Thai corporations overutilizing short-term foreign currency-denominated loans. Republic of Korea (henceforth. Thai corporations were collectively overexposed to exchange rate risks. coupled with financial liberalization and deregulation in the absence of an effective regulatory and supervisory system. and Philippines all depreciating significantly. heralding not only a financial crisis in the country.
Import tariffs on machinery and heavy equipment were removed. This study examines these and other factors that might have weakened corporate sector governance in Thailand. the Government increased tariffs on products that could be produced locally.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. lack of transparency and adequate disclosure.3 looks at corporate ownership patterns that resulted in inadequate protection for minority shareholders and weak corporate governance in Thailand. Section 4. II There is now a consensus that weak governance was partly responsible for the corporate sector’s poor financing and investment practices.2 discusses the development of the Thai corporate sector under the National Economic and Social Development Plans. . with government policy providing support but avoiding direct interference. 4. Section 4.2. the Government implemented major infrastructure projects and modified its tax policy to encourage capital investment and savings. as well as its legal and regulatory framework. The First and Second Plans (1961-1971) Under the first two plans. and a family-based corporate ownership structure. 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. its growth and financial performance. Section 4. To protect domestic industries. focusing mainly on the companies listed in the Stock Exchange of Thailand (SET). The National Economic and Social Development Board was created to plan the country’s economic and social development.5 discusses how the corporate sector contributed to the financial crisis and looks at its impacts. Section 4. while new industries were encouraged to reduce the need for imports. Vol. Key factors that led to weak corporate governance include the ineffectiveness of the regulatory framework.2 4.230 Corporate Governance and Finance in East Asia.1 Overview of the Corporate Sector Historical Development The corporate sector has long been considered the engine of Thailand’s economic growth.
Inflation levels were low. In the wake of lower world oil prices and the rapid growth in income from the tourism and travel industry. Inflation reached 15. However.6 percent per year. Average growth for the period was 4 percent per year. The results were increased exports. and automobile assembly) emerged. External factors.Chapter 4: Thailand 231 During this period. including luxury goods. however. Budget deficits also increased throughout the Fourth Plan. To close the fiscal gap. leaving the Government no choice but to resort to overseas borrowings. processed steel. an improved trade balance. Industrial sector growth was also rapid and many industries (tires. resulted in increases in the current account deficit. the value of the baht remained stable.15 billion per year or 4. Thus. using tax policy to control prices of consumer goods and implementing several price control measures to curb inflation. gross national product grew by about 7 percent per year. became a major problem as domestic investment declined. it proceeded with its development plan for the industrial sector. helped offset these deficits. . including a weakening of the dollar. As a result. and increases in world food and oil prices. lower than anticipated due to a worldwide economic recession. Unemployment. But the sustained importation of heavy machinery and equipment resulted in large trade deficits. canned foods. The average budget deficit reached an all-time high of $2. the government’s debt burden escalated. the industrial sector grew at a faster rate than the agricultural sector. remaining high until 1981. especially foreign aid from the United States. Budget deficits remained a major problem during the Fifth Plan. capital inflows.3 percent in 1974. the current account registered a surplus in 1986. textiles. The Government decided to embark on restructuring measures in the Fifth Plan (1982-1986) to rehabilitate the ailing economy. and Fifth Plans (1972-1986) An economic downturn at the end of the Second Plan led to an adjustment in policies.4 billion from overseas and increased taxes on numerous items. The decline in imports was steady. averaging 1. The Third. however. At the same time. with the devaluation of the baht in 1984 a major step in this direction. chemicals. Fourth. with the agricultural sector the major contributor.4 percent of GDP. and reduced current account deficits. the Government borrowed $6. The Government had to shift emphasis to restoration of economic stability. Consequently. The focus shifted to export promotion.5 percent in 1973 and 24.
compounded by a slump in property sales. and the stock market.8 percent.5 percent.2 percent target. The Seventh Plan (1992-1996) The economy’s performance from 1992 to 1996 generally met the targets of the Seventh Plan. The exchange rate was steady at around B25 to the dollar. rather than to productive activities. increasing its share in total export value from 42 to 76 percent. respectively. the bulk of domestic investments went to speculative ventures such as real estate.5 to 13. from only $31 billion in 1992.2 percent per year.7 and 11. Growth rates during 1987-1991 ranged from 9. On top of its predominantly “borrowed” nature. Private sector investment grew at an average annual rate of 7 percent. invited a deluge of capital seeking profitable investments. compared with the 14. From 1989. Thailand became a debtor’s market.232 Corporate Governance and Finance in East Asia. With loans increasingly becoming expensive and hard to come by due to a lending squeeze by the central bank and high interest rates. the Government successfully balanced the budget and even settled its foreign debt of $4 billion before this was due. Inflation was 4.4 percent targets. compared with the 8. Most of the FDIs—originating mainly from Japan.6 percent. property development. better than the 5. the property sector began to collapse in 1996. averaging 10. . United States. Singapore. with private foreign debt reaching $92 billion by the end of 1996. II The Sixth Plan (1987-1991) Industrial sector productivity improved gradually during the Sixth Plan period. combined with its liberal financial policies.2 and 13. Key to this growth performance was the government’s adoption in 1993 of an aggressive program for attracting foreign capital to finance domestic investments. Growth of exports and imports averaged 14.6 percent target of the Seventh Plan. an oversupply of housing emerged. while exports expanded considerably. Vol. Europe.8 percent. The manufacturing sector became a dominant force in the economy. Average annual growth in real GDP was 8 percent. reaching an annual inflow of $2 billion in 1991. The country’s high ratings in the international capital market. The country also attracted a large amount of foreign direct investments (FDIs). and Hong Kong. China—went to export-oriented manufacturing industries. Thailand’s rapid growth up to the mid-1990s made the country one of the world’s fastest-growing economies. lower than the target of 8. By 1995.
on account of an overvalued baht that weakened export competitiveness. a policy that held throughout the first six economic development plans. the Bank of Thailand and . the Government amended the “Announcement of the Executive Council No. the Government passed the Public Limited Company Act. Included in the Second Plan (1967-1971) was a proposal to establish the country’s first authorized and regulated securities market. the signs of an economy about to falter were there. the corporate sector’s main source of funding was the banks. Before the capital market emerged. placing all publicly listed companies under regulation. In his report. its policy had always been to protect domestic banks. However.2 Development of Capital Markets Although the corporate sector has long been the government’s main tool for economic development. Sidney M. A series of increases in customs and excise taxes on luxury imports did little to stem rampant consumer spending.” which later became the master plan for the development of the Thai capital market. many companies considered the Act too restrictive and a hindrance to growth. the establishment of the Securities Exchange of Thailand (SET) was legislated and trading began on 30 April 1975. which was amended in 1979 and 1985. In 1969. Robbins. In 1978. prepared a comprehensive report entitled “A Capital Market in Thailand.2. 4.8 percent in 1995 to 1. In May 1974.3 percent in 1996. 58 on the Control of Commercial Undertakings Affecting Public Safety and Welfare. And because the Government considered the banking system vital to the development of the economy. In 1972. with growth shrinking from 23. Exports went into a tailspin. SET officially became “the Stock Exchange of Thailand” in 1991. The deficits caused the Government to rely on even more external borrowing. which raised the debt service ratio. The country had a current account deficit of about 8 percent of GDP in 1995 and 1996. 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. Under the 1962 Commercial Banking Act. Foreign banks were barred from competing directly with domestic banks.Chapter 4: Thailand 233 Toward the end of the Plan period. the capital markets didn’t play a significant role until 1975. 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. a former Chief Economist from the US Securities and Exchange Commission.
A number of internal and external factors contributed to the Thai Government’s acceptance of the IMF’s Article VIII agreement. The Public Company Act of 1992 relaxed some of the rules and restrictions contained in the original laws. Thailand’s capital market entered a new era with improved legislation and regulation. The regulatory measures were inadequately designed and poorly enforced. 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. while the Securities and Exchange Act (SEA) the same year sought to improve capital market supervision. the financial and banking laws were generally ineffective.234 Corporate Governance and Finance in East Asia. increased financial market activities. At the end of the Sixth Plan. the Government was under international pressure to deregulate the financial sector. Earlier. 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. and the General Agreement on Tariffs and Trade (GATT) meeting in Uruguay had the liberalization of financial services on its agenda. While the Bank of Thailand had the regulatory power to influence business practices. it usually relied on “moral suasion. The pressure dovetailed with the Government’s intention to make Bangkok one of the financial centers of the region. Thai banks gained access to a variety of funding sources from around the world. The resulting availability of funds propelled the corporate sector’s growth through the early part of the 1990s. the World Bank had recommended such a move. II the Ministry of Finance had full authority to supervise all commercial banks. to cater specifically to its . Economic growth had been rapid and domestic savings could not keep up with the pace to support investments. Financial deregulation and liberalization allowed the country to attract foreign savings and investments that helped finance the growth of the economy. Externally. and new financial instruments. However. Vol. there were 29 commercial banks (15 domestic and 14 foreign banks) in Thailand. Laws were enacted to stimulate growth of the corporate sector. In the 1990s.” The Government also granted financial institutions overly generous bailouts. With the liberalization of financial markets. The banks and finance companies operated at insufficient levels of reserve capital and were overexposed in high-risk businesses such as real estate.
4 trillion in registered capital and B791 billion in paid-up capital. the financial sector is the largest. about 661 companies with total registered capital of B2.3 Growth and Financial Performance Since the 1978 enactment of the Public Limited Company Act.6 1.1 trillion and paid-up capital of B1.5 791.0 19. in that order. Financial deregulation and liberalization were key to realizing that vision. and wholesale/ retail trade and restaurant/hotel sectors. The manufacturing sector is a far second with registered capital of B350 billion and paid-up capital of Table 4. Worldwide. In terms of capital. Real Estate.0 110. Thailand.1 30.2. and Communication Financing. Insurance. and Fishing Mining and Quarrying Manufacturing Electricity.6 23. the country became recognized as an economic development model for other emerging economies.3 83.0 Paid-up Capital (B billion) 1.3 trillion have been registered with the authority (Table 4.2 11. Gas. Source: Department of Commercial Registration. Social and Personal Service Total Note: The data for 2000 is as of October 2000.0 21.2 Type of Business Agriculture.Chapter 4: Thailand 235 fast-growing neighbors. The stock market boom from 1991 until the financial crash of 1997 reflected international investors’ response to Government policies.291. Ministry of Commerce. 4. 1978-2000 Number Registered of Capital Companies (B billion) 5 6 245 5 13 129 22 194 42 661 1.1).394. The result was a corresponding growth and development in Thailand’s capital markets.6 350. however. finance.5 50.9 1.9 16.9 261.101. The majority of the companies are in manufacturing. with B1. Storage. The Bangkok International Banking Facility (BIBF) was thus established to facilitate international borrowings and encourage capital flows as a means of financing the current account deficit. .1 78. and Business Service Community.5 111.6 2. Forestry. and Water Construction Wholesale and Retail Trade. and Restaurants and Hotel Transport.1 Public Companies Registered.9 34. Hunting.
Table 4.8 151.0 0.5 — — 56.7 27. reached .1 286. from only B20. The preeminence of the financial sector is a direct result of financial deregulation and liberalization. While a rebound was apparent beginning in 1998.7 136. 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. The development of the corporate sector closely followed the development of capital markets. Debt market activities also increased significantly with the establishment of the Bond Dealers’ Club (BDC) in 1994.6 39.7 5.1 54.236 Corporate Governance and Finance in East Asia. The number of listed companies and securities steadily increased until 1996 (Table 4.8 billion. II B261 billion.7 billion and B27. respectively. the year before the crisis struck.5 1. The signing of Article VIII with the IMF.2).0 1994 82.6 8.3 1996 1997 65.8 201. Source: Key Capital Market Statistics.3 31. The stock market also became an invaluable source of funds for corporations.4 51.8 — 26.2 Public Offerings of Securities. Domestic and offshore debt issues reached B54.7 9.2 12. meanwhile.6 7.2 40.4 96.9 31.6 174.1 2.7 billion in 1996.8 1995 64. reaching a precrisis peak in 1996 (Table 4.5 39.3).6 — = not available. moreover. Market capitalization.1 599. the capital market became instrumental in the rapid growth and development of the corporate sector.9 37.3 194.2 25. Vol.4 34.3 22. reducing the value of offerings to a little more than a quarter of the previous year’s level. After the passage of the SEA of 1992.9 1998 1999 15. Securities and Exchange Commission of Thailand.0 20.2 5.4 277. the value of public offerings rose steadily. this was due to the recapitalization of commercial banks in compliance with the new loan provisioning requirement.3 6. With the enactment of the SEA of 1992 that brought suppliers of finance services and their clients together.1 — — — 6. allowed Thai financial institutions and corporations to obtain funds overseas.7 7. These peaked at B89. The 1997 crisis battered the primary market for securities.5 billion and B1 billion the previous year.5 1.
The key financial ratios of all companies listed on SET bear this out (Table 4.4 percent in 1996. and gross profit margin.201 2. return on equity (ROE).281 832 373 356 482 Due to listing requirements and other reasons. was the ominous deterioration in the key financial ratios of publicly listed companies.268 2. While the decline in gross profit margin was not as sharp.1 by 1996.610 1. The upward trends for ROE and ROA continued through 1989. ROA dipped from 10. the average times interest earned (TIE) was down to 5.301 3. however. Meanwhile. their share rising from 17 percent in 1993 to 43 percent in 1997. the companies could not generate enough net returns from their assets and equity.133 1. The trend reversed in 1995. pulled down by active public offering activities.5 at its peak in 1987.8 percent.535 1. then stalled in 1990. gross profit margin rose until 1991 before falling in 1992. when long-term debt grew as Thai corporations began to borrow heavily to finance growth. By the early 1990s.560 1. in the end. The plunge in profitability and asset turnover—from 117 percent in 1985 to 65 percent in 1996 for the latter—cast doubts on the . Foreigners accounted for an increasing proportion of SET’s turnover value. Throughout the 1990s. 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. resulting in their inability to fulfill debt obligations.193 2.360 1.Chapter 4: Thailand 237 Table 4. ROE similarly fell from 21.4).325 3. Source: Securities and Exchange Commission of Thailand. From 10. Side by side with this surge of financing for corporate growth. not all public companies are listed on the SET.4 percent to 5. Corporate profitability.114 1.3 percent in 1989 to 3.683 1. corporate profitability had been declining.303 930 855 1. had been on the rise throughout the 1980s. The financial leverage of all companies declined until 1994.3 Statistical Highlights of the Stock Exchange of Thailand.565 2. the highly liquid financial system continued offering cheap funds to sustain corporate sector investments. its high point in 1995 at B3. But instead of shifting to a low gear. however.6 trillion. as measured by return on assets (ROA). the averages for all three profitability ratios took a downswing all the way until 1996.
2 161.7 5.0 7.6 138. US.4 7.2 49.3 10.0 117.1 16. Despite the availability of the equity market.7 LongTerm Debt to Asset Assets Turnover (%) (%) 14.2 215.1 120.8 11. A major reason for this was the rapid rise in asset prices.6 125.7 27. It has also been argued that family-based controlling shareholders borrowed excessively to avoid diluting their control over their corporations.7 21. Overall.7 12.0 145.5). and footwear had the lowest at 11 percent.9 51.4 28.8 54.8 8.4 9.8 25.4 12.5 38.5 30.4 51.1 52. II Table 4.5 15. 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 (%) (%) (%) 3.8 14.2 10.1 60.4 Key Financial Ratios of Publicly Listed Companies. clothing.5 51.2 6.6 27.4 26.9 140.4 7.4 18.4 3. Among the crisis-hit countries.8 88.9 7.4 139.1 114. Thailand’s ROE. the textiles.7 12.6 41.4 44.9 144. large companies (where size is reckoned in terms of assets or sales) were more profitable than small companies in terms of ROE (Table 4.3 4.6 168.7 15.9 27.4 119.5 9.7 12.9 66.0 125. clothing. resulting in higher collateral values for borrowers.2 27. practice of heavy borrowing.1 44.1 242.7 5.0 3.9 8.7 4. The downtrend in corporate profitability.9 77.7 54. but was most severe in building and furnishing material industries as a result of the downturn in the real estate market.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. They were generally more efficient in managing their assets and .8 51.4 47.5 52.3 12.7 20.2 64.4 12. Korea and Thailand had the highest debt-to-equity ratios.3 91.8 5. Severely affected by global competition throughout the decade.4 5.8 151. Vol. and footwear industries also experienced losses.7 12.7 34.9 14. these companies opted for debt.7 27.2 27. which fell from 16 percent in 1991 to just under 6 percent in 1996.2 10.6 7.7 5. Hotels and travel showed the highest ROE of 15 percent while textiles. which was particularly significant in the two years preceding the crisis.3 8.5 63.2 35.238 Corporate Governance and Finance in East Asia. was felt across industries.8 5.1 9.9 39.6 36.6 12.1 16.2 10.4 34.0 139.0 29.7 35.4 24.4 4. was also distinct in the region.7 59.7 80.0 63.5 50.9 7.
4 8. However. The argument was that having a Board of Directors whose members represented different groups of investors would create conflicts and hamper management effectiveness.6 7. although the performance of listed companies in the late 1980s was strong. capital despite the higher gross margins of small companies.5 6.3 23. measured by total asset turnover. Cumulative voting.3 164. weaknesses became evident.6 12. There were also concerns that the provisions governing the criminal prosecution and penalties of directors and management were harsh and inappropriate.5 94. Although stable in the 1980s.9 20.3 49.0 48. In sum.6 30. Increasingly heavy borrowings rendered the sector even more vulnerable to lower profitability and sales.2 10.Chapter 4: Thailand 239 Table 4.2 18.6 30.6 31.6 5.9 13.3 52.8 62. which would be disruptive to company management.7 10.7 14.3 15.1 5. also deteriorated.6 61. the law disallowed cumulative voting.1 25.8 26.2. They also tended to use more financial leverage than small companies as their total DERs show.1 6. the Public Limited Company Act of 1978 and its amendments regulated Thai publicly listed companies. . could lead to a high turnover in the board. the overall activities of listed companies.3 176.3 49.4 Legal and Regulatory Framework Before 1992.8 6.7 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. it was thought.4 52.1 13. During the 1990s.6 6.8 142.5 87. US.2 12.5 Average Key Financial Ratios by Company Size.4 116.3 43.1 29.2 134.0 20.7 6.5 7. 1985-1996 Company Size by Assets Company Size by Sales Item Return on Assets (%) Return on Equity (%) Gross Profit Margin (%) Times Interest Earned Total Debt-to-Equity (%) Long-Term Debt-to-Equity (%) Total Debt-to-Assets (%) Long-Term Debt-to-Assets (%) Asset Turnover (%) Small Medium Large 6.3 25. 4. total asset turnover declined after 1989. some rules and regulations of this particular law were believed to be too restrictive and were discouraging companies from going public. For instance.3 135.3 88.8 6. by the 1990s.8 10.6 10.0 83.8 47.1 Small Medium Large 5.2 121.
The legal and regulatory framework for the corporate sector also includes provisions related to insolvency. As the succeeding sections point out. II Another issue was the proportion of shareholding by top shareholders. As it turned out. as a group. The Public Company Act of 1992.5. adopted to promote the development of publicly listed companies. 2 ADB survey questionnaires were sent to all Thai listed companies in early 1999. and external monitoring and control of corporations were also weak.240 Corporate Governance and Finance in East Asia. but not all questions were answered. The original company owners welcomed the changes and the number of publicly listed companies subsequently rose to more than 600. An Asian Development Bank (ADB) survey conducted for this study shows. 4. played an important role in bringing about the financial crisis. a feature that is believed to have impaired the effectiveness of existing regulatory mechanisms in the corporate sector. the limit on shareholdings by the largest shareholders was increased from 50 to 70 percent of total outstanding shares. . the exit of these provisions appears to have contributed to the 1997 financial crisis. Vol. from holding more than 50 percent of total outstanding shares and other shareholders from holding more than 10 percent of outstanding shares individually.3 Corporate Ownership and Control Ownership and control of corporations in Thailand are highly concentrated. The protection of minority shareholders was inadequate under the Public Company Act of 1992. and the punishment for management misconduct was also lightened considerably. the new legislation removed a number of incentives that would have kept public companies prudent and diligent in their operations. Fortysix companies responded. However. relaxed the contentious provisions of the 1978 Public Limited Company Act. Cumulative voting was made optional. concentrated ownership. coupled with weak corporate governance. This will be discussed in Section 4. for instance.2 The market for corporate control was not active and did not give managers strong incentives to perform efficiently. The provision discouraged original family owners from registering their companies. The law prohibited the largest shareholders. that creditors had generally little influence on the management of corporations.
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.9 percent of shares of a company.0 7.7 6.4 10.6 27.4 6. Most large Thai corporations listed on SET started out as family businesses.2 11.0 5.4 5.3 percent and 18. and 28.1 3.7 7.3 percent.2 4.4 6.0 3.7 12.6 68.4 26. Thai.1 5.9 11.3.1 5.9 52.9 6.8 11. This implies that the top five shareholders enjoyed full control over the outcomes of shareholder meetings. China firms have the highest single shareholder ownership concentration at 35. respectively.1 12. and minority shareholders to stake their claim in the control and regulation of these companies.1 Patterns of Corporate Ownership A World Bank study covering nine Asian countries finds that firms in Japan and Taipei.5 Average for 1990-1998 period.1 11.0 7.9 52.9 4.9 54.8 5.8 32. Table 4. with the top three shareholders accounting for almost 50 percent (Table 4. 1990-1998 Averagea 1990 1991 1992 1993 1994 1995 1996 1997 1998 1st Largest 2nd Largest 3rd Largest 4th Largest 5th Largest Top Five a 28.3 7.2 56. creditors.6 4.3 16.3 11.6 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand.6).9 55.9 3. Stock Exchange of Thailand.China have the least concentrated ownership. with the largest shareholder on average controlling 10. In contrast.4 26.Chapter 4: Thailand 241 4.1 4.4 percent of outstanding shares. one would expect the public.9 3.2 4. this was not the case.3 28. Ownership was most concentrated in the packaging.5 9.3 7.7 percent.5 28. 33.6 57. Ownership Concentration Between 1990 and 1998.0 3. Source: Comprehensive Listed Company Information Database. Indonesian.7 11. and Hong Kong.1 7.1 5.0 56. these companies obtained funding solely from banks or from their own retained earnings.4 4. the top five shareholders of each of publicly listed Thai companies held.6 28.9 26. . In the past.4 26. 56. there were only slight variations in the pattern.9 52. Unfortunately.3 5.0 53.1 percent of control rights. But with their increased reliance on new varieties of equity and debt instruments. Across industries.2 4. on average.
169*** 0. as measured by debt-to-equity and debt-to-asset ratios.7 percent of outstanding shares on average (Table 4.003 0.116) Debt-to-Equity (1. ** at the 5 percent level.031 3. Leverage. results show a significant positive relationship between ownership concentration and financial leverage. Ownership Concentration. On the other hand.080 6. US.034*** 0.029 3. Based on a regression analysis. and building and furnishing industries. 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. owning 26.022*** 0. It is the practice of Thai corporate founding families to set up holding companies to own shares in affiliated companies or subsidiaries.005** 0. These are consistent with the hypothesis that companies with more concentrated ownership tend to engage in higher debt financing because their controlling owners do not want to dilute their control by bringing in new equity holders. Company size is significantly related to ROE and leverage. year.533)*** Debt-to-Assets (0. with a top-five ownership concentration of at least 60 percent. II agribusiness.800 0. Composition of Controlling Shareholders Affiliated corporations comprise the largest group among the top five shareholders of publicly listed companies. Source: Author’s estimation based on the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.058* ROE (0.037 0.242 Corporate Governance and Finance in East Asia. and ownership types.647 Note: The regression included dummy variables for industry. Through these holding companies. * Denotes significance at the 10 percent level.090 0.001) 0.001 0. founding families maintain effective control of entire groups. Vol.7).7 Statistical Relationships between Corporate Profitability. including those that are publicly listed . *** at the 1 percent level.072) (0. and Company Size Item Intercept Top Five Ownership Concentration Company Size Adjusted R-Squared F-Statistic ROA 0. Other industries had their top five shareholders controlling at least 55 percent of outstanding shares. Table 4.8).115 9.001*** 0.
3 percent of outstanding shares. Individual family members also hold a significant amount of outstanding shares.3 20. founding families and their relatives maintain control of many companies by jointly holding on to the most significant chunk of shares.4 1.3 1.2 1.2 7. Source: Comprehensive Listed Company Information Database. including finance and investment companies.5 5.1 0. The roster of its major shareholders as of December 1997 illustrates the typical ownership concentration of a publicly listed company in Thailand.3 1.7 0.0 17.5 0. 1990-1998 Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 Average Company 28. the company. owned by the Chirathivat family.5 26.5 0.1 4.5 percent. The largest shareholder is Central Holdings Company.8 1.9 18.3 1.8 28. In addition.2 5. operates five of the most successful shopping malls in Thailand.6 1.9 0.0 19. Stock Exchange of Thailand. the affiliate firms rarely hold shares of their parent companies. unlike in Japan where crossshareholding is common.8 Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.1 1.6 1. the company increased its registered capital and became a public company listed in SET. individual members of the Chirathivat family aggregately hold 25.9 7.5 1.5 NBFIsa 6.1 1.4 1.3 — = not available.2 18. These individuals usually hold important management positions in concerned companies.3 27.4 20.3 0. a NBFIs denotes nonbank financial institutions.7 Bank 2.Chapter 4: Thailand 243 Table 4.0 18.6 percent of outstanding shares. . In 1994.8 0.9 6.9 15.5 2.5 0.6 25.6 5.4 22. Typically.5 Individuals 13. Established in 1980 with a registered capital of B300 million. a joint venture among three families.6 28.3 27.3 27. Although holding companies set up affiliate firms.7 1.9 19. one of the founding members. with 29.5 Government Other 0.2 1.8 23. averaging about 18.4 1. a company listed in the real estate sector of SET.5 1.0 3.7 — 1. in SET. The top 10 shareholders include a holding company owned by the Tejapaibul family. This practice is illustrated by Central Pattana.6 1.7 5. The ADB survey indicated that listed companies held shares in an average of 11 companies.
II another of the company’s founding members. Only a handful of companies have the Government among their large shareholders. . on average.5 percent of total outstanding shares. and responsibilities of directors of public companies. Together. On average. qualification. In effect. they exercise limited influence in operations because of the restricted size of their shareholdings. By owning 62 percent of voting shares. About half of listed companies have nonbank financial institutions such as finance and investment companies in their top-five shareholder list. Across industries. the Petroleum Authority of Thailand. However. duties. and a state bank. 3 Discussions in this section are based on results of company surveys by SET and ADB. where the top three shareholders are the Ministry of Finance. Vol. the Government owns the majority of the shares. commercial banks account for only 1. Although the list of top shareholders of publicly listed companies includes financial institutions.. 4.2 Corporate Management and Control3 Board of Directors The Public Company Act of 1992 stipulates the appointment process. Another example is Bangchak Petroleum Plc. these shareholders are able to control the company. In such cases. 1. has the Ministry of Finance as its only large shareholder with 92. only one tenth of listed companies have commercial banks on their top-five shareholder list. holdings by individual family members and holding companies account for at least 50 percent of outstanding shares of an average listed company.5 percent of total outstanding shares of listed companies. Moreover. Nonbank financial institutions hold an aggregate 5.244 Corporate Governance and Finance in East Asia. For example. the Government’s role in public companies is expected to decline.3. There was a trend of rising government shareholdings throughout the period 1990 to 1998. Thai Airways International Plc. The Government holds. the predominance of individual family members and holding companies in the top shareholder list remains valid. with the envisioned privatization master plan. both conducted in 1999. roles.1 percent of total outstanding shares of listed companies.9 percent of outstanding shares. Except in the hotel and travel service sector. they account for 80 percent of total outstanding shares. the top 10 shareholders consist predominantly of members of founding families and their holding companies.
but not in 22 others. and to comply with the laws and articles of association. Meanwhile.Chapter 4: Thailand 245 Directors are required to meet minimum qualifications specified under the SEA of 1992 and the Listing Rules issued by SET. A survey by SET found that the majority (58 percent) of the 202 responding companies held their board meetings every quarter. If found in violation of these provisions. directors could be compelled to compensate the company for damages arising from their misconduct. Most companies (83 percent) satisfied SET’s requirement of having two independent board members. that only in two of the 46 responding companies were the chair of the boards elected based on the extent of their shareholdings. an executive board consists of senior management and some main board members. Many companies have a formal policy on corporate governance and business ethics. Some companies (36 percent) had five to six main board members holding seats in their executive boards. In five other companies. Generally. selection was based on relationships with controlling shareholders. Three companies indicated that the CEO and the chair were close relatives. Nineteen companies stated that selection was based on professional qualifications. directors may be imprisoned or fined. Although 28 percent of the chairpersons came from the ranks of independent outside directors. Chair of the Board and Chief Executive Officer The SET survey showed that about 73 percent of listed companies had a separate executive (management) board. . directors are required to act with care and honesty for the company’s best interest. Unless stipulated in public companies’ articles of association. the majority (71 percent) had board chairs who were also members of top management teams. meanwhile. while 30 percent of respondent companies held board meetings monthly. while 15 percent of respondents went beyond the requirement. Almost all companies (98 percent) exceeded the minimum required five members in their Board of Directors. The ADB survey indicated. the ADB survey found that 31 companies (out of 46 responding) required outside directors to be present at all board meetings. In their business conduct. In addition. The appointment of the chief executive officer (CEO) needed approval during the AGSM in 11 of the responding companies. directors shall be elected at the annual general shareholders’ meetings (AGSMs).
the work of this committee was often considered part of the executive board’s responsibilities. while 19 companies observed only some of them. however. and CEO The majority of company respondents to the SET survey provided similar compensation packages to internal and external directors. these were attributed to variations in the extent of duties and responsibilities assumed by those directors. the auditor is not . the majority of the companies (77 percent) did not have outside directors as members of their remuneration committees. the remuneration packages had to be approved during AGSMs. Fourteen other companies had profit-related incentive schemes in addition to fixed fees. Companies already with audit committees did not have independent outside directors as audit committee members. all listed companies have been instructed to establish audit committees to be responsible for examining the quality and reliability of company financial statements. In 25 companies. II Compensation of Directors. Twenty-five of the 46 respondents to the ADB survey declared adherence to all relevant international standards. All respondents confirmed the use of external auditors. with 41 firms admitting the use of services of international auditing firms. The directors’ compensation was determined largely by the Board of Directors except in 19 percent of the companies surveyed where a remuneration committee was in charge. Where different. 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. Three companies allowed their management to determine the chair’s compensation package.246 Corporate Governance and Finance in East Asia. Half of the companies in the SET survey had a separate remuneration committee. In one company. Directors with managerial responsibility or those related to major shareholders cannot be members of such audit committees. Audit Committees and Accounting Standards Since January 1999. The ADB survey indicated that 18 of the 46 responding companies compensated their chairpersons using a fixed-fee schedule. Also. not an independent assignment. Vol. However. The SET survey found that the majority of listed companies (81 percent) still have no separate audit committee. Chair.
The Act also holds directors liable for any damage to shareholders. While safeguards are in place. likewise. Relationships between firms and external auditors are generally long-term. Shareholders are also entitled to call emergency meetings and present proposals at AGSMs. shareholders have access to reliable information at no cost. although recently. there are also significant gaps in the system of shareholder protection. (iii) Because the chair is frequently also part of the top management team. averaging about 14 years. there is the danger that top management may be capable of unduly influencing the board’s decisions. As a result. and the Bank of Thailand— are not clearly defined. (iv) The roles and responsibilities of the major government agencies regulating shareholder rights—the Ministry of Commerce. remuneration. with 13 companies allowing proxy voting through mail. and executive committees. or other financial instruments. as well as the registration and holding of shares. SET’s rules and regulations closely follow this Act. However. (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. shareholders can claim compensation in cases of negligence or dishonesty by management. the institutional machinery is not fully responsive to complaints about violation of shareholder rights. SEC. most responding companies have rules and regulations intended to protect shareholders. including false statements to conceal information about the financial condition and operations of the company during the sale of shares.Chapter 4: Thailand 247 independent from the company. At least 28 responding companies had the following . Minority Shareholders and their Rights Many different rights and entitlements of shareholders are laid out in the Public Company Act of 1992. stipulates the proper conduct of shareholder meetings. The Act. According to the ADB survey. The majority of the companies (85 percent) require the appointment of external auditors during annual general meetings. In the majority of these companies (38 out of 46 respondents). (i) No standards are enforced in the content and timing of notices for shareholder meetings. Proxy solicitation tends to be abused to the extent that shareholders are inadequately informed about matters to be taken up in shareholder assemblies. the Securities and Exchange Commission (SEC) and SET were actively prosecuting violating firms. debentures. For instance. SET. the corporate sector lacks a strong self-regulatory body to compel compliance with these standards. Forty-four companies indicated that they had proxy voting in place.
however. The ADB survey results reveal that the proposals presented by management were rarely rejected during the general meetings. These problems appear to be partly a result of the relaxation of the rules and regulations in the original Public Limited Company Act of 1978.3. the only group of shareholders that can exercise rights is the top five shareholders. and call an extraordinary session. such protection has been insufficient. The difficulty minority shareholders have in exercising their rights can be seen from the ADB survey results. The SEA of 1992 and the listing rules also contain provisions for the protection of shareholders against transfer pricing. they comprised only 8 percent of total shareholders. Almost 82 percent of shareholders. on average. representing only about 28 percent of shareholdings. 66 percent of total outstanding shares. In theory. In effect. . Only a small number of shareholders attended the latest AGSMs. But the exercise of these rights requires even higher shareholding levels. While stimulating the growth of the sector. Written law and its enforcement diverge partly because of a provision that shareholders who take action against erring directors must have at least 5 percent of the total number of shares. the new Public Company Act of 1992 inadvertently weakened the governance of public companies by diminishing minority shareholder rights. In practice. Banks would be obvious candidates to implement these mechanisms. it would be difficult for minority shareholders to gather the shares needed to take action. given their importance in providing finance and their stake in companies. minority shareholders are assured adequate legal protection. II mechanisms in place: mandatory shareholder approval of major transactions and interested or related party transactions. takeover of the company. Although the attendees held.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. did not vote in previous AGSMs. 4. But with the ownership concentration of Thai companies. On paper.248 Corporate Governance and Finance in East Asia. and mandatory disclosure of related interests and significant shareholders’ transactions. Vol. and insider trading. minority shareholders may also appoint an outside inspector to examine the company’s operations and financial condition.
Most companies reported that banks were more likely to require collateral. Only three companies thought otherwise. they resort to borrowing. Only 28 of the responding companies in the ADB survey indicated that their creditors required such feasibility studies. The presence of collateral usually diminishes banks’ incentives for screening project feasibility and monitoring project implementation. borrowers seldom lose control to creditors even when they default and become insolvent. The impact of the financial crisis on credit eligibility and supervision requirements has been significant. Leverage allows the assets and operations of the company to grow without diluting corporate control. the majority believed that creditors had little influence on company management and decision making. However. Among 16 companies in the ADB survey whose loan applications in the last three years were rejected. including procedural disputes. There were many options. which could cause a delay by at least a year. Apparently.Chapter 4: Thailand 249 Historically. For 20 of the 46 responding companies. creditors do not always require project feasibility studies or business plans in granting loans. The old bankruptcy law in Thailand also made it difficult for creditors to obtain payment against bankrupt borrowers. Thailand has relied on commercial banks and finance companies to channel funds to private enterprises. when insiders want to expand their company’s operations without losing control. In the end. a company’s reputation and its long-term relationship with creditors sufficed in many instances. 11 experienced rejection after the crisis started. Seven of the companies responding to the ADB survey indicated that all their creditors required collateral. Fifteen of the 20 companies that had to renegotiate loan repayment with creditors in the last five years did so after the crisis. while 18 said none of their creditors required collateral. other than losing control. Eleven companies stated that creditors usually exercised whatever influence they had on management through covenants regarding the use of loans. . however. Debtors had many handles to stall the bankruptcy process. Actual bankruptcy proceedings took more than five years on average. Normally. Under a weak bankruptcy system. as the ADB survey confirmed. while loans for fixed investment were also more likely to be supported by collateral. creditors’ collateral requirements were tightened after the crisis. One tempering mechanism that could inhibit the excessive use of borrowing is the threat of losing control in the event of bankruptcy. to solve debt repayment problems. such as that seen in Thailand before the crisis. 17 indicated that only some of their creditors had such a requirement.
Although merger and acquisi- .3 billion. which is a general offer made to shareholders of a company to acquire at least 25 percent of outstanding shares. of shareholders: (i) all shareholders must receive tender offers. its main role is to ensure transparency and fairness. The Market for Corporate Control The SEA of 1992 was the first legislation that stipulated rules and regulations regarding the market for corporate control. The second category is the tender offer. the minimum tender offer was reduced to 10 percent and some procedural modifications have also been introduced. there were 41 cases of tender offers. if the purchase of shares implies a change in the directors or business activities.9). however. Vol. whether directly or indirectly. The first category is the acquisition of shares in the open market. In this case. only a limited number of successful mergers of public companies have taken place. a person who acquires more than 5 percent of issued shares must file a report with SEC one day after the date of acquisition. According to the SEA of 1992.250 Corporate Governance and Finance in East Asia. The market for corporate control has not been active in Thailand. It will take years. SEC has no authority to either approve or reject tender offers. and failed to provide managers with strong incentives to perform efficiently. The dearth of tender offers before the crisis suggests that the Thai capital market did not offer a venue for imposing market discipline on corporate management. In 1994 and 1995. There are detailed requirements regarding such notification. The situation remained sluggish in 1997 at nine tender offers and a further decline in total offered value. (ii) an advertisement regarding the tender offer must be placed in major newspapers for at least three consecutive days. there are two categories of merger and acquisition activities with associated regulatory measures. with a total tender offer value of B42. Such efforts would serve to strengthen external discipline on controlling owners. II The financial crisis has presented a unique opportunity for reinventing the framework for corporate bankruptcy and for creating regulatory and judicial precedents. Recently. In 1996. and (iii) tender offers will be effective 30 days after the report has been filed with the SEC. SEC was later made responsible for regulating corporate takeovers. The company has 21 days to evaluate the tender offer and submit a report to SEC and all shareholders. Since the introduction of the Public Limited Company Act of 1978. with a significantly lower total tender offer value of B8.3 billion (Table 4. there were only six tender offers. before the extent to which the bankruptcy framework has been strengthened becomes clear.
but the average shareholding is smaller than 1 percent of total outstanding shares.7 Purchase Value Number of % of Tender Offer Value Companies 84. Source: Securities and Exchange Commission of Thailand.1 75. Employee Participation in Corporate Governance There has been little. Twenty-nine firms indicated that employees held shares of their companies. 1993-1999 Year 1993 1994 1995 1996 1997 1998 1999 a Tender Offer Valuea (B billion) 5. The number of domestic institutional investors rose after the mutual fund industry was established in 1991. . trading by mutual funds in SET represented less than 10 percent of total trading. employee participation in corporate governance in Thailand.7 11.3 11.9 Merger and Acquisition Activities. But instead of opting for an active role in the market for corporate control. it remains small.4 23.2 7.Chapter 4: Thailand 251 Table 4.1 19. Eleven of the 46 responding companies in the ADB survey offer ESOPs.3 60. Because of the current crisis. employees are even less willing to accept common shares as a form of compensation or benefit.6 17. Even when companies offer ESOPs. they have mostly been concerned with short-term gains. Few companies offer employee stock option plans (ESOPs).2 8.1 84. Provident funds for government workers and workers in public enterprises have been established only recently. Since 1994. most of these were forced mergers or related to rescue packages.0 55. if any.8 81.1 58. While the Thai mutual fund industry compares well to those in other developing countries in the region. but employees have never been represented in the board of directors since their shareholdings are minimal. not with a view to becoming involved in actual management.0 B billion 4.2 6.3 6. employees regard the plans as monetary incentives.5 6.9 3. tion activities increased after 1997. Pension funds are perhaps even weaker in Thailand.8 8 27 14 6 9 13 23 Tender offer value refers to the minimum offer value.2 6.
390.5 trillion.559. 1992-1999 (B billion) Outstanding Loans from All Financial Institutions 2.1 Corporate Financing Overview of the Financial Sector A breakdown of the Thai financial sector for the period 1992-1999 (Table 4.171.6 6.193.4 1.119.2 2..5 5.477. .1 7.430.564. II 4.300. The country’s largest bank.6 1.912. accounted for 28 percent of the banking sector’s total assets.8 3.485.4 519.669.9 2.4.1 Domestic Debt Securities Outstanding 215.0 8. 15 of which were domestic banks. there were 29 commercial banks. The share of domestic banks in the banking system’s total assets was 80 percent. the next four largest banks accounted for 63 percent.8 941.4 Year 1992 1993 1994 1995 1996 1997 1998 1999 Source: Stock Exchange of Thailand.037.10) shows that Thailand is a highly bank-dependent economy. total assets of commercial banks amounted to B5.4 3. Table 4. Many large commercial banks had affiliates among the 93 finance companies that served the high-risk market. In 1996.0 424.3 546.4 4.825. The Banking System Until recently.360.3 5.372.268.0 SET Market Capitalization 1.1 3.5 6.10 Size and Composition of the Thai Financial Sector.3 1.0 3.5 4.1 5. Competition from foreign banks was limited as they were not allowed to engage in full branch operations. Bangkok Bank Ltd.133.5 4. The total values of loans from financial institutions and commercial banks were consistently larger than the market capitalization of SET.979. Vol. Thai Bond Dealing Centre.1 3.906. and Bank of Thailand.161.230. the banking sector was highly concentrated.0 339.2 262.1 6.325.775.6 2. The bond market played only a marginal role in corporate financing.663.4 4. although its role increased in the wake of the crisis.5 Outstanding Loans from Commercial Banks 2.252 Corporate Governance and Finance in East Asia.
hardly any progress was made in lowering the cost of domestic financial intermediation or in developing new financial instruments for corporations. Easy access to commercial bank loans by family business groups. owning 70 percent of the country’s second largest bank. an over-the-counter market. In 1993. Because borrowers carried the exchange rate risk. the stock market entered its first boom period in 1986. the market rose steadily and reached a record high in the fourth quarter of 1993. the Bangkok Stock Dealing Center (BSDC). Some 347 companies were listed in the same year with a total market capitalization of B3.2 trillion. due to their close ties. reaching 355. SET was not very active. In contrast. and almost all capital account transactions were deregulated. Many company founders did not want to release even a small portion of corporate ownership and refused to go public.8 in 1998. the SET index declined. Stock prices tripled in the next three years until the market experienced its first crash as a result of the Gulf Crisis in 1990. The Equity Market During the first few years of its operations.3 trillion. also made it unattractive to raise capital from the equity market. Licenses were granted to 15 Thai banks. In the following years. and 20 new foreign banks. BIBF banks also enjoyed tax incentives on their operations and profits. SET is organized into 32 major industries. the liberalization of interest rates and capital account transactions stimulated a credit expansion through short-term borrowings in foreign currency. finance. Banks under the BIBF scheme were allowed to mobilize funds from abroad and lend to Thai companies in foreign currency. the Government established the BIBF to expand the banking sector and reduce the borrowing costs of Thai companies. self-regulatory organization under the . banking.Chapter 4: Thailand 253 The Government was also a major figure in the banking system. and property have accounted for the bulk of trading volumes. Benefiting from rapid economic and industrial growth. After that. The number of listed companies also quadrupled between 1981 and 1993. 12 existing foreign banks. The lack of supply of quality shares was a big problem for SET at that time. SET immediately recovered due to the strength of the Thai economy. The Government removed controls on capital and dividend repatriation in 1991. Turnover value reached B2. was set up by 74 members with an initial capital of B500 million. Through the years. Despite the worldwide market crash in 1987. In 1995. Banking activity peaked in the mid-1990s. BSDC is a nonprofit.
Only one security was listed in BSDC in 1995 and two more in 1996.8 billion in 1996. Listed companies were those that had (i) paid-up capital of at least B20 million. . securities can be traded in the secondary markets. The allocation procedure is nondiscretionary. If the issue is oversubscribed. SET’s primary functions are to serve as a center for the trading of listed securities and to provide the essential systems needed to facilitate securities trading. Its main role is to serve as a secondary market for unlisted companies trying to raise capital. turnover value was negligible and the BSDC Index remained flat throughout 19961998. and pro forma balance sheet and income statements. Company applicants must have an established history of operating under substantially the same management. among other functions approved by SEC. Consequently.5 percent and collectively owning at least 30 percent of paidup capital. II jurisdiction of SEC. The SEA of 1992 installed the legal and regulatory framework for Thai capital markets. A company wishing to qualify for listing in SET must file an information booklet (prospectus) with SEC and SET. lottery drawing must be used to ensure fairness. approved by SET. securities deposit center. stock trading can commence within five days. with each facing different listing requirements. but dropped the following year to B122 million. In July 1990. In 1996. which consist of SET and BSDC. In 1998. SET. Turnover value was B1. and securities registrar. so now only listed companies are traded in SET. After initial public offerings. Before 1993. According to the SEA of 1992. Authorized companies were those with a minimum of 200 shareholders owning collectively at least 25 percent of paid-up capital. SET established new requirements for initial public offerings. The listing application should be submitted concurrently to SEC and SET. financial projections. The primary market is supervised by SEC. Proposed changes in capital must be submitted for approval to SET accompanied by a detailed memorandum outlining the use of proceeds. there were two kinds of companies in SET—“listed” and “authorized” companies. the BSDC was dissolved in 1999. and (ii) a minimum of 300 shareholders. which has a legal mandate to examine a company’s financial status and operations before allowing it to issue securities to the public. If approved by SEC and the SET Board of Governors. The company should then appoint a financial adviser.254 Corporate Governance and Finance in East Asia. however. each holding no more than 0. to assist in the public offering process. It separated the primary and secondary markets to promote more flexible and effective supervision of both. Vol. the two classifications were merged. also acts as a clearinghouse.
and the Government did not issue new bonds during 1990-1997. The budget surpluses of the 1990s eliminated the need for new bond issuance. the first bond rating agency in Thailand. .9 billion. The Thai Rating Information Services. 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. State-owned enterprises became active issuers of bonds since 1993 because the Government constrained their borrowings (Table 4. 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. Companies generally issued short-term debt instruments like promissory notes or bills of exchange. 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. it accounted for a small share of the entire financial sector. which encouraged limited companies and public companies to issue debt instruments. The bond market in Thailand started in 1933. Investors had limited knowledge of debt instruments. In 1996. The proportion of domestic convertible debt instruments increased until 1995. at about 11 percent of the total value of outstanding loans extended by commercial banks and 20 percent of total equity market capitalization. was also instrumental to the growth of the corporate debt market. A breakdown of domestic offerings of corporate debt securities from 1992 to 1996 shows that unsecured debts accounted for about 60 percent. led to the renewed issuance of Government bonds to finance the resurgent budget deficit and support cash-strapped financial institutions. the Government issued more bonds to finance industrial development projects and perennial deficits. in 1994. the size of the corporate debt market rose to B132. However. The recent financial crisis. Four years after the passage of the SEA. the year the Ministry of Finance first issued government bonds to finance infrastructure projects and economic development. compared to 110 percent in the US and 74 percent in Japan in the same year. To gain some perspective of the size of the bond market in Thailand. it represented only 9 percent of GDP. however. Upon its founding in 1942. the Bank of Thailand assumed responsibility for regulating the bond market.Chapter 4: Thailand 255 The Bond Market The Thai bond market has played a marginal role in corporate financing until recently.11). Beginning 1961. A turning point of the corporate debt market was the enactment of the SEA of 1992. while secured debt instruments accounted for just above 10 percent.
0 — 5.0 — 26.7 132.3 3.8 55.5 55.0 0. total offshore debt offerings had plunged by 68 percent to a mere B28.5 — — — — 1.3 22.8 31.1 10.1 141.6 billion.5 10.3 13.5 5. The domestic debt market declined after 1994 because corporations could borrow offshore at lower costs.256 Corporate Governance and Finance in East Asia. The decline in total domestic debt offerings in 1996 can be ascribed to the increase in offshore convertible debts.3 29.9 0.5 — 39.5 37.7 5.6 19.2 39.0 86. BDC was established in November 1994 by 50 securities companies based on the provisions of the SEA of 1992.8 Source: Securities and Exchange Commission of Thailand and the Thai Bond Dealing Centre.1 107.0 333.5 43.1 — — 6.7 538.4 57.8 191.0 60.7 — — — — — 4.7 90.2 43. turnover value had reached B51.0 33. this had climbed to B200.9 30.0 281.4 — — — 1.0 27.2 — — 50.5 138.3 46.2 89.6 — 0. By 1995.1 315.7 0.7 95. However. then declined substantially in 1996 and 1997.7 0.1 61. the year the crisis unraveled and the baht was floated.3 50.0 17.3 — — 3. Total offshore debt offerings peaked in the run-up to the financial crisis.0 26.1 6.8 167. .4 — 26. a surge attributed to capital inflows encouraged by high returns on Thai bonds.4 110.1 21.7 7. 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 — — — — — — 400.9 37.5 billion.7 5.3 140.6 — — 0.7 — — 40.7 28. Vol.4 billion.9 40.3 — 14.0 7. The following year.1 12.0 5.9 329.9 5.4 — 9.9 20.1 289. II Table 4.5 — — 32.3 6. A sharp rise in unsecured offshore debt offerings can be noted all the way through 1996.2 2.3 8.1 41. by the end of 1997.5 — — — 3.3 46.2 57.4 7.1 — — — 29.1 59. The club was considered the first organized secondary bond market in Thailand to serve as the wholesale market for debt securities.5 — 0.7 — — — — — — — 77.1 121.2 45.4 49.7 821.9 37.11 Offerings of Debt Securities.2 28.1 55.8 2.1 8.0 — 5.8 47.
significant variations can be noted. listed companies experienced liquidity problems with declining reserves of cash and marketable securities during the period 1990 to 1996 (Table 4. with equity levels remaining high despite an increase in debt. Longterm loans accounted for about 20 percent of total liabilities. For the construction industry.Chapter 4: Thailand 257 compared with investment in equities. There was also little change in the trend in retained earnings within the seven-year period.2 Patterns of Corporate Financing An examination of financing patterns among Thai companies listed in SET shows that on the asset side. Retained earnings accounted for about 30 percent of total equity financing. these accounted for 33 percent of total liabilities. At lower than 5 percent of total liabilities. In the same year. overall asset quality and liquidity of listed Thai companies deteriorated throughout the period. the use of debentures remains minimal even though the trend was generally upward until the 1997 crisis. The overall trend is consistent with the decline in profitability observed in the analysis of corporate sector performance earlier. BDC was renamed “the Thai Bond Dealing Centre” following its status upgrade to a bond exchange. short-term loans accounted for more than 40 percent of total liabilities. while for the property development industry. Across industries. judging by their relatively low levels of retained earnings. From 1990 to 1996. The ratio of net working capital to total assets decreased from a peak of 31 percent in 1993 to 28 percent in 1996. 4. Turnover fell further to B72. In addition. Equity financing remains an important part of listed companies’ long-term financing.4. Thailand’s publicly listed companies rely mainly on loans from commercial banks and financial institutions to finance their growth. and marketable securities holdings.2 billion as a result of the default of debentures due to the Asian crisis. cash balances. Companies in construction and property development seemed unable to generate internal funds. turnover value plummeted to B106. The average for all industries was only 22 percent. a trend most apparent in the leap between 1991 and 1992. In any case. these comprised 31 percent.1 billion in 1998. Construction and property development industries tended to have high proportions of long-term loans and debentures. The proportion of accounts receivable also declined steadily. they also had a relatively small proportion of equity and .12). The closure of 58 finance companies affected the BDC significantly since half of its members were suspended as a result. In 1997. steadily easing up between 1990 and 1996.
9 40.8 3.3 1. compared with the 44 percent general average.9 12.1 18.1 50.0 10.9 15.4 14.6 6.2 3.9 17.7 16.7 15.0 100.4 2.8 37.2 1.8 9.9 10. The agribusiness industry relied more heavily on short-term loans at 56 percent of the industry’s total liabilities.0 51.0 100.2 17.6 51.0 100.9 14.2 1.6 2. Analysis of common-size statements by ownership concentration (based on the levels of top-five ownership concentration classified as high.5 1.9 14.9 14.0 48.258 Corporate Governance and Finance in East Asia.1 7.3 6.9 18.3 17.3 2.5 1.0 7.8 34.2 17. Printing and publishing companies had lower financial leverage than companies in other industries.8 10.7 18.6 0.3 12.5 11.0 100.8 14.6 18.3 50.8 6.0 2.8 19.3 38.6 8. The level of total liabilities for the group characterized by high ownership concentration .6 0.2 17.9 20. US.0 13.7 9.0 100.2 16.8 20.8 1.8 37.7 50.9 2. 1990-1996 (percent) Item All Years 1990 1991 1992 1993 1994 1995 1996 2.2 2.3 25.9 0.1 36.4 7.2 2.3 1.4 17.9 17.2 43.6 12.2 35.3 49.9 6.2 12.8 35. medium.3 21.7 7.0 100.4 43.12 Common-Size Statements for Companies Listed in SET.8 9.3 18.5 0.3 48.1 13.9 49.1 17.2 2.4 17.7 36.7 14.0 10.9 50.9 6.0 100.2 45.0 15.4 48.0 6.4 49.6 50.6 100.3 14.0 100.9 16.1 5.3 34.2 43. were highly leveraged.3 34.2 17.8 8.6 36.8 17.7 52.9 38.5 1.2 15.9 3.5 37.6 100.0 100.7 1.13).5 9.6 13.6 10.9 14.5 43. Vol.2 16.2 34.4 49.6 15.3 14.7 17.8 25.7 0.7 16.0 14.2 42.6 22.3 18.9 43.6 0.4 8.0 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.2 22.2 2.0 100.6 11.2 1. II Table 4.6 0.6 21. and low) also underscores that companies with high ownership concentration had high levels of long-term loans (Table 4.1 49.6 38.0 100.5 9.8 7.0 100.9 14.8 46.4 21.6 14.8 21.0 100.4 6.0 100.5 14.0 12.1 2.0 1.
7 12.6 100.4 35. 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 2.0 19. was 53 percent of total assets compared with 49.3 100.4 49.9 2.4 50. .7 17.3 35.0 Medium 2.9 21.5 percent for low ownership concentration companies.Chapter 4: Thailand 259 Table 4.8 13.0 6.5 11.0 Low 1.0 41.5 100.9 7.2 0.2 8.13 Common-Size Statements of Public Companies by Ownership Concentration.1 53.2 45.6 14.4 13.6 2.6 0.0 6.4 1.6 9.0 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.4 18.7 19.1 49. US. Companies with medium ownership concentration tended to have a higher proportion of short-term loans. common equity accounted for a smaller proportion of total assets (47 percent) than companies with lower ownership concentration.6 47.3 16.6 22.1 18.5 21.0 7.7 percent for medium ownership concentration companies and 49.0 100.8 37.8 13.0 100.1 44.1 36.4 37.9 50.5 18.9 0.8 12. This is consistent with the observation that majority shareholders try to maintain their control by utilizing debt as a major source of funds.9 36.4 7.0 14.3 8.2 11.5 13.3 1.9 100. For the high ownership concentration group.9 16.0 16.3 1.2 22.6 15.2 14.4 3.
8 65. especially from 1994 to 1996.8 5. the choice of financing is determined by the company’s liquidity considerations. The financing patterns indicate that companies with high ownership concentration were more highly leveraged than companies with medium and low concentration.9 140.7 28.1 44.9 7. More important. As a result.15. Such deterioration of financial positions during the period was a common feature of listed companies.2 35.0 145.7 in 1994 to 5.5 52.3 61.7 percent in 1996.0 25. Short-term debt accounted for most of the increase.1 16. these firms more easily increased their leverage.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.6 41.4 12.7 11. Table 4.7 34. however. and rights issues. followed by bank loans.6 7.7 12.1 31.0 28. and maintenance of the existing ownership structure.14).4 5. Generally. Vol.4 7.8 percent in 1990 to 52. 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 8.4 139.1 52.5 38.1 23. thus rendering them more vulnerable. The direct relationship between the degree of leverage and the degree of ownership concentration is apparent in Table 4. Public companies relied more on short-term debt financing in the period before the financial crisis.1 64.8 51. was the headlong deterioration of firms’ ability to meet their interest payment obligations. The TIE ratio declined from its peak of 7.1 144.4 44.6 125.9 14. An overall picture of SET-listed companies’ financing and investment patterns in the 1990s shows a steady rise in the use of financial leverage (Table 4.1 in 1996. bond issues overtook loans from commercial banks as the second preference.0 50.7 34. While further detailed investigations are necessary.3 31.8 151.9 51.1 16. The ratio of total debt to total assets increased from 50.6 138.4 51. After the crisis. minimization of transaction and interest costs. US. .9 63. bond issues. however.7 5.8 65.2 49.2 68.14 Financial Ratios of All Listed Firms.7 12.260 Corporate Governance and Finance in East Asia.7 66.1 31. it would seem that firms with concentrated ownership and associated links to the banking system have easier access to debt financing. II Results from the ADB survey reveal that Thai companies preferred to use reserves and retained earnings as their first choice of financing.
0 64. From only 34 percent in 1986. US. however.5.4 27.3 42. The corporate sector contributed significantly to the crisis because of its rising levels of leverage.1 The Corporate Sector during the Financial Crisis Impact of the Financial Crisis on the Corporate Sector The financial crisis came after a period of rapid growth in the Thai economy.4 63.4 13. The proportion of external debt as a percentage of GDP consequently increased from 42.5 percent of external debt in 1996 (Table 4. Their average annual growth rate declined from 28. on the other hand.5 126.9 percent in 1997.16).2 percent in 1986 to 251.5 148.8 28.8 29.Chapter 4: Thailand 261 Table 4. such as direct equity and portfolio investment.7 percent from 1991 to 1996. 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 27.4 52. peaking in 1994 at 84 percent. is even more telling. the proportion of short-term debt increased from 15.6 11. This decline was accompanied.2 124. continued to slide from 1985 to 1997.8 49. 4. debt-creating capital inflows rose to 65 percent in 1990. The composition and term-structure of this debt. private debt accounted for 84. 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 6.5 percent between 1985 and 1990 to 8. unhedged foreign exchange liabilities.8 Medium 7.2 49.4 percent to 46 percent during the same period.5 4.6 30.1 High 6.8 percent in 1986 to 52 percent in 1995. Additionally. . The proportion of nondebt-creating capital flows.8 66.8 14. and a preponderance of short-term debt liabilities. From 45 percent of total net capital movements in 1985.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.15 Financial Ratios of Listed Companies by Ownership Concentration.5 34.
5 4.9 3.8 108.16 External Debt.4 — — — — — — — 1.9 31.1 64.6 Total 18.1 0.5 14.7 10.3 16.9 3.3 12.1 30.4 18.9 1.7 23.0 21.2 0.8 3.3 37.7 13.2 32.5 12.0 4.1 0.6 — 0.7 2.4 3.1 Source: Bank of Thailand. .5 12.1 0.6 1.3 3.9 10.1 2.3 0.1 5.2 0.9 10.0 0.4 5.5 19.9 6.2 2.1 22.1 34.4 15.9 43.3 0.0 3.9 4.9 35.4 2.3 0.3 2.1 95.7 20.3 3.6 Government Year Long-Term Short-Term 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 12.Table 4.9 6.2 15.2 0.1 0.0 Long-Term Short-Term BIBF Commercial Bank Long-Term Short-Term 0.3 7.3 0.2 10.5 16.1 23.1 12.9 100.2 2.3 0.8 12.9 1.3 — — — — — — — 6.0 13.9 13.7 0.8 10.8 3.9 11.5 1.4 10.0 11.2 2.9 29.3 105.8 0.2 14.0 8.9 7.6 18.3 10.6 7.7 109.8 13.9 5.3 20. 1986-1999 ($ billion) Private Nonbank Long-Term Short-Term 3.5 4.0 6.7 24.0 11.6 52.3 0.7 1.8 31.3 0.9 0.3 0.
exposing the companies to disaster when the baht started tumbling on 2 July 1997. reaching 45 percent of total outstanding credit in December. trading activity at SET had been on the downturn.6 in December 1996. closures.Chapter 4: Thailand 263 This shows that although banking and finance companies suffered most because of their short-term exposure. from its peak in 1995. banks would be recording more of such NPLs. large Thai companies had actively borrowed at low interest rates from foreign financial institutions. The severity of the impact of the crisis on the corporate sector was apparent from (i) the decline in the volume of public offerings. foreign currency-denominated debts constituted 55 percent of their total debt portfolio. according to the Bank of Thailand. (ii) the rise in the nonperforming loan (NPL) ratio and consequent tightening of credit even for viable firms. and (iii) bankruptcies. the number of newly registered companies dropped to a 10-year low in 1998. Trading volume has since been thin. . Foreign investors retreated from the market. On average. the SET Index stood at 1.6 billion from the 1996 level of B201 billion. It hit a 10-year low in the second quarter of 1998.281 in December 1995 and to 831. The proportion of NPLs as a percentage of outstanding loans demonstrates the liquidity problem experienced by the corporate sector. Even before the crisis.360. nonfinancial companies also experienced severe liquidity problems as a result of the baht’s devaluation. SET’s dismal performance is indicative of the extent of the setback suffered by the Thai capital market. The effects of the crisis were felt across all industry sectors. Due in part to liquidity problems on the one hand. leaving domestic investors with large capital losses. After that. Meanwhile. If lending rates remained high. outstanding credit also declined throughout the second half of 1998. suggesting that serious investors have not returned to the market. and drastic decline in the number and capital of newly registered companies. the numbers of bankruptcies and company closures reached all-time highs in 1998 (Table 4. Similarly. NPLs spiraled from 12 percent in the second quarter of 1997 to almost 40 percent in the third quarter of 1998. the index declined to 1. With easy access to foreign funds. At the end of 1994. The value of public offerings sank in 1997 to B56. based on the three-month past due definition. and poor business confidence on the other. the liquidity problems faced by the corporate sector are likely to continue for some time. 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.17). Most of these foreign debts were not properly hedged. Aside from the problem of NPLs.
But when assistance from other sources did not materialize.334 4.5.2 Responses to the Crisis Initially.224 4.902 3.904 20.066 19.134 31. II Table 4. Vol.307 4.695 3.080 9. The first Letter of Intent was cosigned by the Minister of Finance and the Governor of the Bank of Thailand on 14 August 1997.677 Bankrupted/Closed 2. the Government was left with no choice.777 11. As part of the assistance package.409 6.925 12.915 37.2 billion for balance of payments support and buildup of the country’s reserves.112 9. .977 Source: Department of Commercial Registration. the Thai Government was lukewarm to the idea of obtaining IMF assistance because of the requirements and conditions attached to the financial package.17 Number of Newly Registered and Bankrupted/Closed Companies. The IMF financial package was a credit facility of $17. Ministry of Commerce.410 37.410 5.6 in 1997. 1985-1999 Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Newly Registered 10. A steady price decline over the past few years has dragged down the ratio of market price to book value.201 24.312 25.797 4.218 3.792 7. Thailand. The increase of the P/E ratio in 1998 was mostly a result of a decrease in earnings for most listed companies.095 14.105 4.052 36.933 25. IMF required Thailand to meet a set of performance criteria and implement various restructuring measures.407 28. It also explains the higher dividend yield ratio.264 Corporate Governance and Finance in East Asia. 4.5 at the end of 1994 to 12 in 1996 and further to 6.096 22.288 35. The price-to-earnings (P/E) ratio deteriorated from 19.
the Civil and Commercial Code. and did not recognize debtor-initiated bankruptcy declarations. Securities. Many believed that the process was inefficient. increase profitability. The Government required all remaining financial institutions to recapitalize and instituted closer monitoring measures to ensure full compliance with this requirement. The Bank of Thailand also improved banking standards. Regulatory Response by the Government The IMF program. and worked on revisions to the Secured Transaction Law. Several changes in the banking and financial policy environment have been effected in line with the restructuring program. and the Act Regulating the Finance. The Government also passed the Bankruptcy Act and Foreclosure Act Amendments. There were many options for solving debt repayment problems. By invoking procedural loopholes. These include repeal of the Commercial Bank Act. Under the old bankruptcy laws. secured creditors had to obtain the court’s approval before starting proceedings .” Creditors thus bore the burden of proving a debtor’s insolvency before the courts. and if necessary. They could seek civil action through the courts and could also use criminal sanctions to enforce debt repayments. As it turned out. The core of the IMF conditionalities was the restructuring of the banking and financial sector to regain investor confidence. also aimed at institutionalizing legal and regulatory reforms. however. Strict loan classifications. loan provisioning. it was widely interpreted as “having debts more than assets. only two companies emerged intact from the suspension. The Financial Sector Restructuring Authority was established in October 1997 to address the problems of 58 finance companies that were suspended in 1997. debtors could drag out the process for many years. IMF relaxed these key conditions. The old law allowed only creditors to file bankruptcy suits. In early 1998. While no definition for “insolvency” could be found in the bankruptcy law. and income recognition were implemented. The assets of the other companies were liquidated by auctions. and restore solvency. Creditors could negotiate to reschedule debt repayments. For example. creditors seldom succeeded in obtaining payment against bankrupt borrowers. follow through with a civil or bankruptcy suit.Chapter 4: Thailand 265 The terms of the agreement required the Government to maintain tight monetary and fiscal policies. drawn up with World Bank and ADB assistance. and Credit Foncier Businesses.
Companies need . but it is a complicated. Foreign secured creditors had to go through the motions of establishing that their country of domicile granted Thai creditors similar rights. it covers only the court-supervised reorganization of distressed companies. a remedy beneficial to borrowers and creditors is made possible through a business reorganization that should improve the borrower’s debt position and ensure its continued operations. In Thailand. In effect. If the process fails to revive the business. Chapter 11 cases account for only 5 percent of bankruptcy suits in the US but consume 90 percent of the courts’ time. and (iv) the debts shall have been settled within a five-year period. the National Assembly passed an amended Bankruptcy Act and approved the establishment of special bankruptcy courts. Under the old Bankruptcy Act. To make matters worse for creditors. The reorganization process is successful if (i) the debts shall have been discharged. any new loan to a company extended after the creditor discovered the insolvency would not be eligible for repayment. The original Bankruptcy Act dealt only with liquidation and composition. (ii) management of the company reverts to the borrower. The model for Thailand’s amended bankruptcy law was the US Chapter 11. The amendment added reorganization provisions to the Bankruptcy Act of 1940. Enforcement of the new law is bound to be ponderous and lengthy. the amended law limits the rights of secured creditors.266 Corporate Governance and Finance in East Asia. For one. Vol. which means that a debtor could continue in business while the reorganization program was being implemented. The amended law also introduced the concept of automatic stay. There are other potential problems. II for the recovery of debt through the realization of any collateral. 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 is the main tool in restructuring bankrupted companies in the US. creditors always had to contend with the threat of disruptions in a delinquent borrower’s business. the main purpose of which is to assist in the rehabilitation process so that a company can repay its debt and still retain its assets while remaining in business. the company shall be declared bankrupt and liquidation of assets shall follow. thereby allowing court-supervised corporate restructuring. (iii) shareholders regain their legal rights. the judges and court officers have yet to learn and master the new bankruptcy procedure. In 1999. time consuming. But more important. and expensive process. The amended legislation also includes voluntary bankruptcy as a new feature.
Still pending Parliament approval is the amendment to the Secured Transaction Law. which aims to increase liquidity in the domestic economy by allowing businesses to use both tangible and intangible assets in securing credit. The new foreclosure law cuts short the procedures required under the Civil and Commercial Code for petty or simple cases dealing with mortgage defaults: (i) submission by the drafting committee of a default judgment bill within a week. the court.Chapter 4: Thailand 267 to solve the problems (e. The proposed amendment also includes a provision for the company to reimburse minority shareholders for expenses related to calling such a meeting.. the test for insolvency still uses the balance sheet criterion. SEC also examined the possibility of an amendment to the Public Company Act of 1992. minority shareholders’ rights are not adequately protected. however. . The amendment also remedies the slow process of executing or disposing of assets in a public auction. Consequently. The minimum shareholding requirement is too high for any individuals or groups of minority shareholders to take action against controlling shareholders. Under the new law. the Bankruptcy Amendment will just prolong the problems of nonviable borrowers. Replacing the Public Limited Company Act of 1978. questions have been raised regarding the appropriateness of the 1992 Act. namely “liabilities exceed assets. 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.” as opposed to the more appropriate criterion of “ability to pay when the debt falls due. The result. shall have the power to call the extraordinary general meeting. after determining the legitimacy of the request. The proposed new law seeks to expand the type of assets that a borrower can use as collateral. corporate governance) that caused the bankruptcy in the first place. and (ii) processing of default cases within four to six months of filing of a court claim. only tangible assets were the norm. the 1992 Act relaxed some of the original restrictive rules and regulations to encourage public company registration.” The Foreclosure Act Amendment was likewise passed in 2000. Most important. Without the necessary corporate restructuring.g. In the past. 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. has not been satisfactory. The amendment seeks to revise old rules and procedures that tended to delay foreclosure proceedings. Procedural delays give borrowers an advantage because they can refuse to pay back their loans even though they can meet their obligations. In case the board of directors does not comply.
Otherwise. The 1992 Act also allows directors to engage in business activities that may directly or indirectly affect the company.e. This may be true in countries where publicly traded companies are widely held. they face the prospect of being unable to compete for the scarce funds available in the equities market. 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. who are also the managers.. II Another issue is the assumption in the 1992 Act that there is a separation of ownership and control functions. without cumulative voting. with the approval of the board. and determine voting results on virtually any matter. minority shareholders are likely to be wary of increasing their equity without corresponding control mechanisms at their disposal. i. 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. However. In addition. But because this is the assumption embedded in the regulation. the main problem is overlooked. Consequently. The textbook separation between owners who sit in the company’s board and professional managers who run the company does not apply in Thailand. Where equity will come forward. to borrow from the company without consideration to the fairness of the transaction or transparency of the approval process. Vol. Because of high ownership concentration. in turn. In the absence of such a stock market boom now. Most companies decide against cumulative voting. the dominance of controlling shareholders. But as demonstrated. The proposal for the amendment of the Public .268 Corporate Governance and Finance in East Asia. subject only to approval by the board of directors. disrupts the company’s management and decision making. The regulators are drafting a proposal to amend the provisions on related transactions. it permits directors. vis-a-vis the minority shareholders. it will probably be expensive because of the higher risk that comes with weak accountability mechanisms. there are few provisions in the Act that deal with related or connected transactions that potentially reduce shareholders’ value. claiming that it creates fragmentation in the board of directors. the controlling shareholders have the exclusive domain to appoint or exercise management. The proposal clearly delineates duties of care and loyalty for directors of public companies. The 1992 Act only prescribes—not requires—the use of the cumulative voting procedure. which. 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. minority shareholders have no chance of being represented in the board. this is not so in publicly traded companies in Thailand.
Within three months. and procedures for debt restructuring. 322. In response. personal consumption. will be settled by the courts. the mere threat of external control alters the incentives faced by managers and controlling shareholders significantly. However. This point is crucial because compared with . Some 82 percent of these cases have been successfully restructured. The first bankruptcy court in Thailand opened on 18 June 1999. Cases for which negotiations were unsuccessful. only 7. Commercial banks initiated 74 percent of these cases. the number of cases has abated.6 trillion) have agreed to cooperate with CDRAC’s restructuring process.6 trillion. The reason is that bankruptcy law amendments appear to facilitate settlements outside the court.8 trillion had been completed. Considerable progress has been achieved on this front. contributing to the unprecedented rise in the corporate sector’s bad debt. accounting for B1. where bankruptcy procedures are swift and effective. although since then. Another 5 percent of cases (B70 billion) are undergoing restructuring negotiations. CDRAC’s target debtors comprised 10.1 trillion in outstanding credit. Corporate Debt Restructuring and Bankruptcy The 1997 crisis led to a severe liquidity problem in the economy. In particular. 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. Equally important is the contribution of effective and reliable bankruptcy procedures for improved corporate governance. By October 2000.1 trillion of outstanding credit.767 cases involving outstanding credit of B2. accounting for B1.147 cases (B1. In addition. with the majority of the debtors coming from the commerce. Reforms in bankruptcy procedures should be seen not only in the context of crisis resolution. As of November 2000.068 cases involving B475 billion are undergoing restructuring.Chapter 4: Thailand 269 Company Act of 1992 includes a recommendation to require all public companies to use cumulative voting to ensure that the board of directors consists of representatives from all groups of shareholders. the court had more than 80 cases for disposition. methods. Another 77. and manufacturing sectors. as well as those that did not cooperate with CDRAC’s restructuring process.764 debt restructuring cases involving B1. the Government introduced debt restructuring-related measures to help resolve bad debts. The Bank of Thailand issued guidelines in 1998 encouraging financial institutions to specify their own policies.
The . to push companies to harmonize their accounting with international standards. 4.6. In the next three decades. Weak bankruptcy procedures were part and parcel of the perverse set of incentives that led firms to build up unsustainable levels of debt. the Government protected certain corporate sectors through tariffs and regulation. Such improvements in disclosure standards are part of the efforts of SET and SEC. a time span that includes the onset of financial liberalization—the turning point of Thai economic development in the last decade—and represents the decade preceding the Asian financial crisis of 1997. Reforms through SET and Improved Disclosure The financial crisis prompted SET to introduce a range of improvements to its operation and regulation. 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. Philippines.1 Summary. 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. Vol. For this reason. behavior. Emphasis was on the structure of corporate governance and patterns of corporate ownership and financing of publicly listed companies. and performance during this period helps understand the causes of the crisis. and Recommendations Summary and Conclusions This study has provided an overview of the corporate sector and governance in Thailand. The banking industry played a key role in the early stages of economic development because it represented the only avenue for funding Thai corporations. and promoted key industries through incentives. the Thai Government managed its economy with the corporate sector as the main engine of growth and development.270 Corporate Governance and Finance in East Asia. The study covers the period 1985 to 1996. despite the weakness of their disciplinary powers. Examination of corporate ownership.6 4. The exchange has already required that listed companies’ quarterly reports be directly comparable with annual statements. II Malaysia. It required listed companies to establish their own audit committees by the end of 1999. Conclusions. Financial information from listed companies will also soon be required to conform to International Accounting Standards.
One of the major findings is the high ownership concentration among Thai companies listed on SET. One of the principal causes of the crisis was the excessive use of foreign debt by the corporate sector. Profitability increased throughout the 1980s but began to decline in the first half of the 1990s. the number and value of public offerings of securities accelerated. The study examined the impact of ownership structure on corporate governance and financing patterns. the numbers of bankruptcy cases and company closures reached alltime highs. reaching its peak in 1996.Chapter 4: Thailand 271 importance of bank financing continued throughout the 1990s. the increase in long-term debt more than compensated for the drop. 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. Consequently. Although there are some variations across industries. the Public Company Act of 1992 and the SEA of 1992. Minority shareholders. the overall corporate sector was seriously affected. . Thai companies were vulnerable to exchange rate risks. At the same time. Financial liberalization apparently encouraged companies to borrow overseas to finance investments that were not productively employed. the profitability of publicly listed companies abruptly declined and their financial leverage increased. the number of listed companies in SET fell from 454 in 1996 to 392 in 1999. During 1992-1997. Although there was a decline in short-term foreign debt. The number of newly registered companies in 1997 dropped by almost 10. The impact of the crisis was felt across all industries. the corporate sector entered a new era with the enactment of two major pieces of legislation. the devaluation of the baht that began on 2 July 1997 affected the financial condition of Thai corporations. foreign debt in the Thai corporate sector increased continuously. In 1995 and 1996. the top five largest shareholders hold about 56 percent of total outstanding shares. At the onset of the 1997 financial crisis. Meanwhile. The SEA of 1992 also marked the beginning of an active bond market in Thailand. at a time when most of them were already experiencing declining profits and high leverage. After 1992. there was a marked increase in the number of public corporations. Subsequently.000 from the previous year’s level. even after the development of capital markets. the overall pattern of ownership concentration seems to have been stable for the past 10 years. On average. Nonbank private corporations accounted for most of the increase. Because most of these debts were not hedged. In 1992. The financial performance of the corporate sector remained satisfactory up to the years before the outbreak of the financial crisis.
The highly concentrated ownership structure weakens the protection of minority shareholder rights. averaging 46 percent. The key laws. holding companies and affiliated corporations hold the largest proportion at 27 percent of total outstanding shares. Thus. 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. foreign and domestic. hold only a small portion of total outstanding shares. The Government holds about 1 percent of total outstanding shares but these holdings represent majority shares of a few companies. In the past. protect the interests of all shareholders of public companies. are not active. The rules in both Acts governing . These laws stipulate rules and regulations concerning the activities of all public companies. contribute to the lack of external controls on the corporate sector through the capital markets. Institutional investors in Thailand. there is a clear lack of outside monitors for these publicly listed but family-controlled companies. With financial institutions playing limited roles in the capital market. Vol. the Public Company Act of 1992 and the SEA of 1992. Financial institutions hold a very small proportion. Consequently. along with a highly concentrated ownership structure. All these. II although larger in number. 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. The implications of ownership structures that are concentrated to such a high degree are serious. An analysis of the corporate ownership structure in Thailand suggests that founders and management continue to own and control publicly listed Thai companies. Nominally. the government pension fund was the only major institutional investor. Most foreign institutional investors invest only on a short-term basis and aim for short-term trading profits. Recently.272 Corporate Governance and Finance in East Asia. the existing legal and regulatory framework suggests otherwise. they have little influence over management decision making and control. the mutual fund industry has entered the picture but with limited roles and activities. Among the five largest shareholders of Thai companies listed on SET. publicly listed and unlisted companies in Thailand are equally subject to the consequences of the risk-taking behavior of controlling owners. Individuals and insiders hold the second largest proportion at about 19 percent. through the use of holding and affiliated companies. commercial banks hold only about 2 percent of total outstanding shares while nonbank financial institutions hold about 6 percent.
For instance. Specifically. but is significantly related to financing patterns. the main challenge is in protecting minority shareholders from the possibility of expropriation by the majority. The ownership structure of Thai listed companies also significantly affects company behavior. Ownership concentration appears to have little impact on corporate profit performance. However. It appears that founding family members use debt extensively to finance investments because they want to preserve control of their firms. making them vulnerable to economic shocks. Certain provisions. . before the crisis. Rather. the Public Company Act of 1992 allows shareholders to act only when they hold a minimum proportion of shareholdings. In this third area. the high ownership concentration of many listed Thai companies inhibits the effectiveness of these provisions. the main challenge is not how the board can control management to maximize shareholder value. 4. posed formidable barriers in the minority shareholders’ exercise of their rights. moreover. laws did not provide minority shareholders sufficient safeguards in cases of transactions involving companies where the controlling shareholders had related interests. Consequently. For example. key reforms that will strengthen the regulation of financial institutions. these companies tend to become overleveraged. because there is no separation between ownership and management. an aim that can be achieved mostly through legal reforms. The first issue involves the development of a comprehensive supervisory framework and the strengthening of the capacity of supervisory agencies. In view of this.Chapter 4: Thailand 273 minority shareholders’ participation in decision making and in initiatives against management conform to international standards. the degree of ownership concentration has a statistically significant positive relationship to the degree of financial leverage. The second issue involves the protection of shareholder rights.2 Policy Recommendations There are three major policy issues and recommendations that could improve corporate governance in Thailand. The Government has been moving to amend the Public Company Act of 1992 to increase minority shareholders’ protection in this regard. The third issue involves creating external market controls through better regulation and development of the capital markets. because there are shared interests between the controlling shareholders and key management personnel. a requirement impossible to meet due to the concentrated shareholdings of founding family members and management.6.
Under the current system. and increase the participation of institutional investors are imperative. Vol. he/she often has the decisive vote. If this were the situation. In reality. . SET was mandated to supervise listed companies. As in other crisis economies in the region. activate the market for corporate control. this is a problem in Thailand. the supervisory system is fragmented and not as effective as it should be. If the principal shareholder is in fact chair of the board. the key issue in corporate governance would then be to ensure that managers act in the best interests of the shareholders. the principal shareholder typically plays a key role in management and often serves as the chief executive officer. Consequently. The best approach may entail establishing a single. Only then will these agencies be able to act promptly and effectively. the key issue in corporate governance is how to prevent insiders from expropriating assets of minority shareholders. In this setting. unified supervisory agency or a permanent regulatory division consisting of supervisory units from the three agencies. voting only on major decisions. The board therefore plays a pivotal role. with control delegated to professional managers. in most of Thailand’s publicly traded firms. Development of a Comprehensive Supervisory Framework There is a need for the Government to establish a comprehensive supervisory framework for the corporate sector. The owners of a firm rely on a board of directors to supervise the managers. and SEC) are involved in corporate supervision. Once the roles and responsibilities are clearly defined. and after the enactment of the SEA in 1992. The Government must develop an overall framework for corporate sector supervision and redefine the regulatory jurisdiction of each agency along functional lines. SEC was established as another supervisory agency. three major government organizations (the Ministry of Commerce. SET. the Ministry of Commerce had the sole supervisory responsibility. There is also supposed to be separation of ownership and control. It is important that the roles and responsibilities of each agency are clearly defined to the public. This is due to the historical development of the Thai corporate sector: before 1975. the supervisory agencies also need to be empowered to enforce the laws. II encourage market competition. in 1975.274 Corporate Governance and Finance in East Asia. Protection of Shareholder Rights The common assumption is that publicly traded corporations are widely dispersed in terms of ownership.
The first recommendation involves the repeal of current legislation to allow minority shareholders to have greater influence over management decision making. accountability. Since the Asian financial crisis. There is also a need for legislation dealing with nominee or holding companies because they are the institutional means that founding family members use to maintain control. Current laws allow a high degree of ownership concentration and provide inadequate safeguards against possible conflict-of-interest transactions and their impact on minority shareholders. This move is expected to be unpopular among founding family members and original owners. Because these holding companies control a number of large public companies in Thailand. The Ministry of Commerce is conducting a study on proposed amendments to the Public Company Act of 1992. But weaknesses in accounting and auditing practices have been inhibiting the development of capital markets. the Government can change the shareholding limit for controlling shareholders. they should be monitored and regulated. there has been much progress in this area. and a prohibition of connected transactions by directors or management. The second recommendation is to dilute ownership concentration through the use of regulatory power. requiring cumulative voting for the election of directors. Some of the legal reforms under consideration concern settling conflictof-interest situations with significant effects on minority shareholders. increasing penalties for directors engaged in misconduct. The situation prompts two specific recommendations. Through an amendment in the Public Company Act. and . SEC is exploring the possibility of amending the law toward this direction. SEC has been trying to lay the foundations of good corporate governance by espousing fairness. The slow improvement in the legal framework has likewise obstructed progress in this area. To ensure a level playing field. regulators must increase transparency and step up enforcement.Chapter 4: Thailand 275 There is a need to recognize the unique ownership structure in Thailand and its effects on corporate investment and financing behavior. This includes prescribing ways to empower minority shareholders without disrupting the company’s operations. The Government does not have an effective way of monitoring the financial activities of these companies even as it is widely believed that a large amount of funds is being channeled through them. transparency. 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.
However. Capital Market Development and Regulation Another important issue concerns the development of capital markets. Accounting standards have also been under review. for instance. a well-developed secondary market will pave the way for market disciplinary forces to act against poorly managed companies. The Bank of Thailand’s enforcement of prudent lending practices among Thai financial institutions. A well-developed domestic debt market will provide corporations with an alternative to bank financing. Because the financing of Thailand’s corporate sector is predominantly bank-based and will remain so for a long while yet. In the stock market. the power of the capital market to discipline inefficient management is almost nonexistent. One way the Government can improve the current situation is to require publicly listed companies to trade a higher proportion of outstanding shares in the secondary market. which. will incidentally close off easy sources of finance for companies that have been practicing regulatory arbitrage. will lead to the emergence of a reference yield curve. there is a need to increase market disciplinary power through market competition. Without a strong and efficient capital market. Further. The same goes for improvements in the bankruptcy system. In an environment of highly concentrated ownership. The promotion of active roles for domestic institutional investors should also improve corporate governance in Thailand. Vol. while a strong domestic debt market will also offer protection from foreign exchange risk. the SEC’s disposition toward a largely voluntary approach for adoption of these characteristics has resulted in uneven compliance among public companies. Thailand should develop a strong public debt market to supplement the banking system in financing corporate investments. especially in the area of connected lending. II responsibility among companies. There will be no incentive for companies to raise capital in the equities market if they can obtain funds at a lower cost elsewhere.276 Corporate Governance and Finance in East Asia. This may not be possible without reforms in the banking sector itself. The variety of debt instruments available to the corporate sector and investors should be increased and longer-term sources of bond finance actively promoted. in turn. it is important to explore reforms that can lead to the enhanced role of banks in monitoring enterprises. aimed at ensuring that banks finance only creditworthy projects. it will be difficult to improve corporate governance in Thailand. The first step is to establish an active secondary Government bond market. .
Pacific-Basin Capital Markets Research Center. Thai Accounting Standards. PACAP-Thailand Database. 1995. 1998. The Securities and Exchange Commission of Thailand. The University of Rhode Island. Thailand. 1997. The Thai Bond Dealing Centre. Fact Book. . US. Bond Market Development in Thailand. Bank of Thailand. 1997-1999. Kingston. 1997. The Stock Market in Thailand. Bank of Thailand Monthly Bulletin. Key Capital Market Statistics. The Stock Exchange of Thailand. 1995-1999. 1995-1999. Bank of Thailand Quarterly Bulletin. Department of Commercial Registration Database. The Securities and Exchange Commission of Thailand. Ministry of Commerce.Chapter 4: Thailand 277 References Annual Report. The Stock Exchange of Thailand. The Stock Exchange of Thailand. Bank of Thailand. 1995-1999.
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